The actual dynamics (as opposed to the risk-neutral dynamics) of the forward rate curve cannot be reduced to that of the short rate: the statistical evidence points out to the necessity of taking into account more degrees of freedom in order to represent in an adequate fashion the complicated deformations of the term structure. In particular, the imperfect correlation between maturities and the rich variety of term structure deformations shows that a one factor model is too rigid to describe yield curve dynamics.
Furthermore, in practice the value of the short rate is either fixed or at least strongly influenced by an authority exterior to the market (the central banks), through a mechanism different in nature from that which determines rates of higher maturities which are negotiated on the market. The short rate can therefore be viewed as an exogenous stochastic input which then gives rise to a deformation of the term structure as the market adjusts to its variations.
Traditional term structure models define – implicitly or explicitly – the random motion of an infinite number of forward rates as diffusions driven by a finite number of independent Brownian motions. This choice may appear surprising, since it introduces a lot of constraints on the type of evolution one can ascribe to each point of the forward rate curve and greatly reduces the dimensionality i.e. the number of degrees of freedom of the model, such that the resulting model is not able to reproduce any more the complex dynamics of the term structure. Multifactor models are usually justified by refering to the results of principal component analysis of term structure fluctuations. However, one should note that the quantities of interest when dealing with the term structure of interest rates are not the first two moments of the forward rates but typically involve expectations of non-linear functions of the forward rate curve: caps and floors are typical examples from this point of view. Hence, although a multifactor model might explain the variance of the forward rate itself, the same model may not be able to explain correctly the variability of portfolio positions involving non-linear combinations of the same forward rates. In other words, a principal component whose associated eigenvalue is small may have a non-negligible effect on the fluctuations of a non-linear function of forward rates. This question is especially relevant when calculating quantiles and Value-at-Risk measures.
In a multifactor model with k sources of randomness, one can use any k + 1 instruments to hedge a given risky payoff. However, this is not what traders do in real markets: a given interest-rate contingent payoff is hedged with bonds of the same maturity. These practices reflect the existence of a risk specific to instruments of a given maturity. The representation of a maturity-specific risk means that, in a continuous-maturity limit, one must also allow the number of sources of randomness to grow with the number of maturities; otherwise one loses the localization in maturity of the source of randomness in the model.
An important ingredient for the tractability of a model is its Markovian character. Non-Markov processes are difficult to simulate and even harder to manipulate analytically. Of course, any process can be transformed into a Markov process if it is imbedded into a space of sufficiently high dimension; this amounts to injecting a sufficient number of “state variables” into the model. These state variables may or may not be observable quantities; for example one such state variable may be the short rate itself but another one could be an economic variable whose value is not deducible from knowledge of the forward rate curve. If the state variables are not directly observed, they are obtainable in principle from the observed interest rates by a filtering process. Nevertheless the presence of unobserved state variables makes the model more difficult to handle both in terms of interpretation and statistical estimation. This drawback has motivated the development of so-called affine curve models models where one imposes that the state variables be affine functions of the observed yield curve. While the affine hypothesis is not necessarily realistic from an empirical point of view, it has the property of directly relating state variables to the observed term structure.
Another feature of term structure movements is that, as a curve, the forward rate curve displays a continuous deformation: configurations of the forward rate curve at dates not too far from each other tend to be similar. Most applications require the yield curve to have some degree of smoothness e.g. differentiability with respect to the maturity. This is not only a purely mathematical requirement but is reflected in market practices of hedging and arbitrage on fixed income instruments. Market practitioners tend to hedge an interest rate risk of a given maturity with instruments of the same maturity or close to it. This important observation means that the maturity is not simply a way of indexing the family of forward rates: market operators expect forward rates whose maturities are close to behave similarly. Moreover, the model should account for the observation that the volatility term structure displays a hump but that multiple humps are never observed.