Skip to content

IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

An actuary compares a two-factor interest rate model with a one-factor model for hedging a book of long-dated liabilities. What is the main practical advantage of the two-factor model?

A two-factor model can capture non-parallel movements in the yield curve, such as changes in slope, because yields at different maturities are not perfectly correlated. A one-factor model implies perfect correlation across maturities, which limits its usefulness for hedging long-dated liabilities.

  1. AIt removes the need for any calibration
  2. BIt allows non-parallel yield curve movements, such as changes in slope, to be capturedCorrect
  3. CIt guarantees that interest rates are always positive
  4. DIt makes bond prices independent of volatility
  5. It forces all yields at different maturities to be perfectly correlated

Explanation

One-factor models imply that yields at all maturities are perfectly correlated, so only parallel-type shifts in shape are driven by one source of risk. A second factor lets slope or curvature change independently, improving hedging. It still needs calibration and does not itself ensure positive rates.

Did you get it right without looking?

One question tells you little. A timed set on Models of the term structure of interest rates shows your real accuracy, how long you take and where you lose marks.

Practise Models of the term structure of interest ratesFree diagnostic mock

More Models of the term structure of interest rates questions