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

A trader calibrates a constant-drift model to the market and obtains a positive λ, because the yield curve slopes upward. The trader concludes that the market expects the short rate to rise by λ per year in the real world. Which statement best assesses this conclusion?

The conclusion is invalid. The calibrated λ is the risk-neutral drift, which blends expected rate changes with the risk premium investors demand. Prices alone cannot separate the two, so λ should not be read as the market's real-world forecast of rising rates.

  1. AIt is valid, because λ is the real-world expected change in the short rate.
  2. BIt is invalid, because λ is always zero once convexity is included.
  3. CIt is invalid, because λ is the risk-neutral drift, which combines expected rate changes with compensation for risk and so cannot be read as a pure forecast.Correct
  4. DIt is valid, because a positive λ means the volatility σ is also positive.

Explanation

The calibrated λ is a risk-neutral drift, set to match market prices. It reflects both expected changes in rates and risk premium. The two cannot be separated from prices alone, so λ is not a real-world forecast.

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