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FRM Part II · FRM Exam Part II · The Art of Term Structure Models: Drift

A bank's ALM team observes that a bond with maturity 10 years is priced by a model with no arbitrage using risk-neutral drift, and the model's calibrated short rate drift is the sum of an expected change and a risk premium. If market participants are risk averse and demand compensation for interest rate risk, how does the risk-neutral drift compare with the real-world drift of the short rate?

The risk-neutral drift is higher than the real-world drift when investors are risk averse. A positive risk premium means bonds are priced to offer higher expected returns, which means lower prices and higher discount rates, shown as a larger risk-neutral drift in the short rate.

  1. AThe risk-neutral drift is higher than the real-world driftCorrect
  2. BThe risk-neutral drift is lower than the real-world drift
  3. CThey are equal, since no-arbitrage requires identical drifts
  4. DThe comparison depends only on volatility and never on the risk premium

Explanation

With a positive risk premium, investors require higher expected returns on bonds, so bond prices are lower than under real-world expectations. Lower prices correspond to higher discount rates, which is represented by a higher risk-neutral short-rate drift than the real-world drift. Equal drifts would imply zero risk premium.

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