**Yield Curve Data**

The model is calibrated from historical daily yield curve data over the last five years. The yield curve structure contains 51 tenors ranging from 1M to 25Y.

Evolution of daily historical yield curve data with 51 tenors over 5 years. Each line represents a different tenor |

Evolution of daily historical yield curve data with 51 tenors over 5 years. Each line represents different day in the past, while the horizontal axis represents tenor space. |

**Principal Component Analysis**

**The principal component analysis is then used to identify common factors which are driving movements in these rates. Typically 3-5 factors are sufficient to explain dynamics of the yield curve.**

**Volatility Fitting**

Once the volatility factors are identified in historical data by PCA technique, cubic spline interpolator is used to fit these factors. These interpolators are then later used to generate discrete mesh of tenors for the purpose of Monte Carlo simulation.

**Risk-neutral Drift Calculation**

**Drift function is calculated using numerical integration over fitted volatility functions**

**Monte Carlo Simulation**

**Monte Carlo Simulation with risk-neutral drift is used to generate evolution of yield curve for different simulation paths in order to price IR Caplet with strike 3%, expiring in one and maturing in two years.**

More information in IPython notebook

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