FRM Part II · FRM Exam Part II · The Art of Term Structure Models: Drift
A Ho-Lee model has σ = 0.80% per year and the initial forward-rate curve is flat at 3.00% for all maturities. What is the calibrated drift λ(t) at t = 5 years, expressed in percent per year?
The drift is 0.032% per year. With a flat forward curve the slope term is zero, so the drift is just σ²t, which is 0.008 squared times 5, equal to 0.00032. Ignoring convexity would give zero, which is wrong.
- A0.0000%
- B0.0032%
- C0.0320%Correct
- D0.0064%
Explanation
The flat curve gives ∂F/∂t = 0, so λ(t) = σ²t. With σ = 0.008, σ² = 0.000064; times 5 = 0.00032 = 0.032%. 0.0032% mis-scales by ten. 0.0064% uses t = 1 in decimal error-style scaling. 0.0000% ignores convexity.
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