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FRM Part II · FRM Exam Part II · The Vasicek and Gauss+ Models

In a Gauss+ type model with a fast-reverting first factor and a slow-reverting second factor, a shock hits both factors simultaneously. Several years later, which feature of the yield curve response is most likely?

After several years the fast-reverting factor's shock has mostly decayed, so the remaining curve displacement mainly reflects the slow-reverting factor. Higher mean-reversion speed means faster decay of shocks, and neither factor is permanent when mean reversion is positive.

  1. AThe fast factor's effect has largely decayed, so the remaining displacement mainly reflects the slow factorCorrect
  2. BBoth factors' effects are unchanged because shocks are permanent
  3. CThe fast factor dominates long-maturity yields
  4. DThe slow factor's effect has vanished faster than the fast factor's

Explanation

A higher mean-reversion speed means shocks decay faster, so after several years the fast factor's shock is largely gone. What remains is the slow factor's persistent displacement. Shocks are not permanent when mean reversion is positive.

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