I am reading up on interest rate models, but currently confused about difference in the two types of models:

  1. no arb models like ho-lee, vasicek etc.

  2. others like nelson siegel, pca models etc.

While I get the basics of fitting the params etc in the models using observed yields, I am not if these models are even used for the same problems? Can Nelson siegel be classified as a short rate model? Are short rate models only used for pricing options? Can both of these be used to "fit" a curve and find relative value?

  • 2
    $\begingroup$ No arb stochastic models are used to price derivatives (such as options) by, in essence, generating plausible random values of a single interest rate. Nelson Siegel is not a short rate model but a representation of the yield curve, essentially an interpolation or curve fitting technique. PCA produces a parsimonious description of historical yield curve changes, it is a statistical technique more than a model. $\endgroup$ – Alex C Sep 3 '18 at 3:18
  • 1
    $\begingroup$ The yield curves produced by Ho-Lee, Vasicek, etc. are not very realistic so it does not make much sense to fit them to the real yield curve to find relative value (it is going to be a relatively poor fit). Techniques in point 2. are better for that. $\endgroup$ – Alex C Sep 3 '18 at 19:34

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