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FRM Part II · FRM Exam Part II · The Vasicek and Gauss+ Models

A practitioner notes that Gauss+ style models are often used with a time-dependent drift function fitted to today's curve. What is the main purpose of this fitting?

The drift is fitted so the model reproduces today's observed bond or swap prices. This anchors pricing and hedging in the current market term structure, which is essential for valuing derivatives consistently, and it does not eliminate volatility or negative rates.

  1. ATo make model bond prices match observed market prices so that pricing and hedging start from the current term structureCorrect
  2. BTo remove all volatility from the short rate
  3. CTo guarantee that the short rate never falls below zero
  4. DTo force the long-run mean reversion level to equal the current short rate

Explanation

Fitting the drift to the current curve ensures the model reproduces observed bond or swap prices, a requirement for consistent pricing and hedging of derivatives. It does not remove volatility, prevent negative rates in a Gaussian model, or set the reversion level to the current rate.

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