Skip to content

IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

A practitioner wants a short-rate model that reproduces exactly today's observed zero-coupon bond prices in the Indian government securities market, so that it can be used to price interest rate derivatives consistently with the market. Which model feature achieves this?

A time-dependent drift chosen to fit the initial term structure, as in Hull-White, lets the model reproduce today's observed zero-coupon bond prices exactly. Constant-parameter models like Vasicek or CIR have too few degrees of freedom to match an arbitrary observed yield curve.

  1. AA time-dependent drift parameter chosen to fit the initial term structure, as in the Hull-White modelCorrect
  2. BA constant long-run mean level as in the basic Vasicek model
  3. CA constant volatility parameter estimated from historical data
  4. DA square-root volatility term as in the CIR model
  5. A single mean-reversion speed estimated by regression

Explanation

Models with a time-dependent drift, such as Hull-White (extended Vasicek), are calibrated so that model bond prices match the observed initial curve. Vasicek and CIR with constant parameters generally cannot match an arbitrary curve exactly. Volatility or mean-reversion choices do not guarantee a fit to the curve.

Did you get it right without looking?

One question tells you little. A timed set on Models of the term structure of interest rates shows your real accuracy, how long you take and where you lose marks.

Practise Models of the term structure of interest ratesFree diagnostic mock

More Models of the term structure of interest rates questions