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FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models

A bank uses a one-factor Vasicek model to value a zero-coupon bond. Compared with using Ho-Lee with the same σ, what is a key practical advantage of Vasicek for long-dated risk management?

Vasicek's mean reversion pulls rates toward a long-run level and bounds long-horizon variance, so long-term rate distributions are more realistic than in Ho-Lee. It still permits negative rates and does not fit any curve exactly.

  1. AMean reversion keeps long-horizon rate dispersion bounded, giving more realistic long-term rate distributionsCorrect
  2. BIt guarantees that interest rates can never be negative
  3. CIt fits any observed term structure exactly without recalibration
  4. DIt removes the need to specify a market price of risk

Explanation

Vasicek's mean reversion limits long-horizon variance and gives more plausible long-term behaviour. However, rates remain normally distributed and can be negative. The basic constant-parameter Vasicek cannot fit an arbitrary curve exactly, and risk pricing still involves a risk premium parameter.

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