What is the Chen Model?

In 1994, economist Lin Chen published a mathematical model designed to illustrate how interest rates evolve. The Chen Model is a short-rate model, also called a three-factor model, for determining how interest rates will evolve in the future based on the short rate. Analysts determine short rate by a mathematical equation involving annualized interest rates for borrowed money and extremely short time periods. The Chen Model was the first such short-rate model to include stochastic mean and stochastic volatility.

In the world of finance, the Chen Model helps predict interest rates to help determine pricing structures for securities, bonds and stock trading, as well as expected returns on investments. It is one of many finance theories and models used to predict future financial conditions. The Chen Model seeks to calculate future evolution of interest rates based on market risks. The risks used to calculate expected returns and thus set pricing are market return, forecasts for future market returns and market volatility forecasts.

With the Chen Model, Lin Chen attempted to use mathematical finance theories and equations to account for numerous possible future outcomes. By changing certain variables, economists and financial professionals have a better view of potential risk scenarios. As such, securities pricing, especially those securities involving bidding on purchase price or hedging futures, allows for fluctuation in the market with less risk of loss. The risk tolerance of a particular security determines how likely investors are to buy into that security.

Fixed income investments, also known as debt securities, are subject to losing money because of changes in interest rates and price behavior. Debt securities or fixed income investments include bonds issued by companies, organizations and governments. These investments also are a primary component of hedge portfolios. Investors and investment management firms rely heavily on fixed income analysis using mathematical models such as the Chen Model. Analysts make recommendations to invest in or pass on certain securities based on the results of such mathematical analyses.

The primary basis for debt securities is loaning money with the expectation of a specific return in a short period of time. For example, investors purchase bonds from corporations at discounted rates to provide companies with borrowed funds for various operations. When the bond matures, investors expect to yield a certain amount based on interest rates and the face value of the bond. If interest rates deviate well out of forecast ranges, investors might not realize the full return they expected. The Chen Model seeks to predict future interest rates to help assess the risk of such a scenario.