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

A risk analyst compares a model with constant drift and constant volatility, dr = λ dt + σ dw, to the Ho-Lee model, dr = λ(t) dt + σ dw. What is the main practical advantage of Ho-Lee's time-dependent drift?

The Ho-Lee model's time-dependent drift can be chosen so the model reproduces today's observed term structure of bond prices or spot rates. It does not add mean reversion, prevent negative rates, or make volatility depend on the rate level.

  1. AIt allows the model to be calibrated to match the current term structure of spot rates or bond pricesCorrect
  2. BIt makes the short rate mean-revert to a long-run level
  3. CIt guarantees that the short rate can never become negative
  4. DIt lets volatility decline as the rate level falls

Explanation

Ho-Lee lets the drift λ(t) vary with time, so it can be chosen to reproduce the observed market curve exactly. It has no mean reversion, it permits negative rates because the distribution is normal, and its volatility is constant.

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