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

In a Model 2 setting, a trader observes that the market 10-year spot rate is below the model's value computed with the historical (real-world) drift. The trader concludes that the risk-neutral drift is lower than the real-world drift. Which interpretation is most consistent with term structure theory?

The difference is consistent with a risk premium: the drift under the pricing measure can differ from the historical drift. Calibrating the risk-neutral λ to market bond prices is appropriate, and the gap does not imply arbitrage or zero volatility.

  1. AThe model is arbitrageable and must be rejected
  2. BInvestors are paid a negative risk premium in the model, which is inconsistent with any rate model
  3. CMarket prices embed a risk premium so that λ under the pricing measure can differ from the historical drift; calibrating λ to market prices is appropriateCorrect
  4. DVolatility must be zero for the market rate to be lower

Explanation

Pricing uses the risk-neutral drift, which can differ from the historical drift by a risk premium term, positive or negative. Calibrating λ to observed prices is the standard approach. A difference does not imply arbitrage or zero volatility.

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