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

A risk manager compares Ho-Lee with Vasicek for a portfolio of long-dated bonds. Which statement correctly contrasts the two models?

Ho-Lee uses a time-dependent drift to fit the initial term structure exactly but has no mean reversion. Basic Vasicek has mean reversion toward a constant long-run rate but cannot fit an arbitrary curve exactly. Both permit negative rates because rates are normally distributed.

  1. AHo-Lee can fit the initial term structure exactly via time-dependent drift but has no mean reversion, whereas basic Vasicek has mean reversion but a constant long-run rate and cannot fit an arbitrary curve exactlyCorrect
  2. BHo-Lee has mean reversion and constant drift, whereas Vasicek has a time-dependent drift
  3. CBoth models imply that the short-rate volatility shrinks with horizon
  4. DHo-Lee ensures positive rates while Vasicek permits negative rates

Explanation

Ho-Lee's λ(t) allows an exact fit to the initial curve, but rates are not mean-reverting, so long-horizon rate variance grows with t. Basic Vasicek reverts to a constant level and, with few parameters, cannot match an arbitrary curve. Both use normally distributed rates, so both permit negatives.

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