The mainstream research in interest-rate modeling has been focusing on a collection of risk tools and pricing formulas which are developed based on the simplified market assumptions and hypotheses. Despite the elegance of the structure, it is noticed that a crucial yet natural factor is missing: the relationship between curve-fitting algorithms and no-arbitrage restrictions on a bond portfolio. Also, the discrepancy between risk-free and default-free bonds is often ignored. This study discusses the modeling conundrums and proposes a framework based on the preferred-habitat hypothesis for advanced term-structure construction that overcomes these limitations in current models. This article serves as an introduction for future work.
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