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How do we explain the difference beween a single and multi factor interest rate model. Short term interest rate is one of the factor which is used in drift and vol calculation but what are other factors which can impact the yield curve and can be included in the simulation.

I am trying to understand the motivation behind it.

Thanks!

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A single factor models implies that all moves across the entire curve are driven by a single source of randomness. If you look at PCA analyses done on yourself curve changes, they typically identify multiple independent components (the first three of these identify with level, slope, curvature changes). Of these, level is the most important, so with a 1 factor model you do capture the biggest driver. But for some applications, you might need multiple of these.

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  • $\begingroup$ Thanks Bram. Please also tell what are the popular factors used. Like Short term interest rate is one factor, what can be other ones? $\endgroup$ – SaurabhD Jan 30 at 0:06

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