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

A risk manager notes that Ho-Lee calibrates perfectly to today's curve but is criticised for the shape of future rate dynamics. Which criticism is valid for the Ho-Lee model?

The valid criticism is that Ho-Lee has no mean reversion and constant volatility, so rate variance grows without bound with the horizon and shocks are parallel across maturities. It can be calibrated to the curve and permits negative rates.

  1. AWithout mean reversion, long-horizon rate variance grows without bound and the model implies the same volatility for all maturitiesCorrect
  2. BIt cannot be calibrated to the initial curve
  3. CIts rate distribution is lognormal so rates cannot be negative
  4. DIts drift is constant over time so it cannot fit an upward-sloping curve

Explanation

Ho-Lee has constant volatility and no mean reversion, so rate variance σ²T keeps rising and rate changes across maturities are perfectly parallel. It is normal, so negative rates are possible, and its time-dependent drift does fit any curve.

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