Skip to content

FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models

A risk analyst compares the Ho-Lee model, dr = λ(t)dt + σdw, with a model that has no time-dependent drift. Which statement about the role of λ(t) in Ho-Lee is correct?

In Ho-Lee, λ(t) is a time-dependent drift calibrated so that model-implied bond prices match the current market term structure. It does not provide mean reversion and does not prevent negative rates, because the short rate is normally distributed.

  1. AIt is chosen so the model reproduces the current market term structure of bond pricesCorrect
  2. BIt controls the speed at which rates revert to a long-run mean
  3. CIt is set equal to the short-rate volatility to ensure no arbitrage
  4. DIt makes the short rate strictly positive in all states

Explanation

In Ho-Lee, the time-dependent drift λ(t) is calibrated so that model prices match the observed bond or spot curve. Mean reversion is a feature of Vasicek, not Ho-Lee. Ho-Lee has normally distributed rates, so negative rates remain possible.

Did you get it right without looking?

One question tells you little. A timed set on Arbitrage Pricing with Term Structure Models shows your real accuracy, how long you take and where you lose marks.

Practise Arbitrage Pricing with Term Structure ModelsFree diagnostic mock

More Arbitrage Pricing with Term Structure Models questions