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

A risk manager compares Model 1 (zero drift) with Model 2 (constant positive risk-neutral drift λ) with the same σ. Holding r0 fixed, how does moving from Model 1 to Model 2 change the 5-year zero-coupon bond price, ignoring any change in σ?

The bond price falls. Positive risk-neutral drift raises the expected path of short rates, which increases the average discounting rate over the five years. The convexity effect depends on volatility, not drift, so it does not offset this.

  1. APrice falls, because the expected path of rates is higher and discounting is heavierCorrect
  2. BPrice rises, because positive drift increases convexity
  3. CPrice is unchanged, because drift cancels with volatility
  4. DPrice rises, because higher rates raise the discount factor

Explanation

Positive risk-neutral drift raises expected future short rates, increasing the average discount rate and lowering the zero-coupon price. Convexity depends on σ, not λ. Higher rates reduce, not raise, discount factors.

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