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

A risk analyst compares two short-rate models: Model A has dr = λ dt + σ dw with constant λ, and Model B (Ho-Lee) has dr = λ(t) dt + σ dw. Which statement best describes the key advantage of Model B?

The Ho-Lee model's time-dependent drift λ(t) can be chosen so that model bond prices match the observed term structure exactly. A constant-drift model cannot do this. Ho-Lee does not add mean reversion, does not stop negative rates, and still depends on volatility.

  1. AIt prevents the short rate from ever becoming negative
  2. BIts time-dependent drift can be calibrated so model prices match the observed term structure of bond pricesCorrect
  3. CIt removes all dependence on the volatility parameter when pricing bonds
  4. DIt introduces mean reversion toward a long-run rate

Explanation

The Ho-Lee drift λ(t) is a function of time chosen to fit the initial market curve exactly. Model A with constant drift cannot match an arbitrary curve. Ho-Lee has no mean reversion and normally distributed rates, so negative rates remain possible.

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