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

Which statement about calibrating a multifactor Gaussian short-rate model is most accurate?

Adding factors lets a multifactor Gaussian model reproduce more of the observed co-movement of yields across maturities, such as level and slope effects, but it increases the number of parameters to calibrate. It does not remove negative-rate possibility, which remains because the factors are Gaussian.

  1. AAdding factors always reduces the number of parameters to estimate
  2. BAdditional factors let the model fit more of the observed covariance structure of yields, at the cost of more parametersCorrect
  3. CA second factor eliminates the possibility of negative rates
  4. DCalibration only requires matching the current short rate

Explanation

More factors allow the model to match richer yield-curve co-movement such as level and slope, but each adds mean reversion and volatility parameters. Gaussian factors still permit negative rates, and fitting involves the whole curve and volatilities, not only the short rate.

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