Skip to content

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

In the Vasicek model dr = k(θ − r)dt + σ dw, a risk manager observes that the short rate is currently well above θ. Which statement best describes the expected behavior of the rate over the next small interval, ignoring the random shock?

The drift is negative. In the Vasicek model the drift is k(θ − r), so when the short rate is above the long-run level θ the expected change is downward, pulling the rate back toward θ. This is the mean-reversion property of the model.

  1. AThe drift is negative, pulling the rate down toward θCorrect
  2. BThe drift is positive, pushing the rate further above θ
  3. CThe drift is zero because the volatility term dominates
  4. DThe drift equals σ regardless of the rate level

Explanation

Drift is k(θ − r). When r exceeds θ, the term (θ − r) is negative and k is positive, so the expected change is negative. The rate is pulled back toward θ. Option B has the sign reversed.

Did you get it right without looking?

One question tells you little. A timed set on The Art of Term Structure Models: Drift shows your real accuracy, how long you take and where you lose marks.

Practise The Art of Term Structure Models: DriftFree diagnostic mock

More The Art of Term Structure Models: Drift questions