Tuckman : The art of term structure models: drift
4 important questions on Tuckman : The art of term structure models: drift
A problem with Gaussian models is that the short-term rate can become negative. What remedies are offered?
- Assume a non-normal distrubution (e.g. log normal, but may result in unacceptable volatilities)
- Use shadow rates (construct rate trees with whatever distribution is desired, and then simply set all negative rates to zero).
Describe the Ho-Lee Model
Model for term structures with a time dependent drift: it assumes the drift changes over time.
What are the differences between an arbitrade-free model vs. equilibrium model?
Arbitrage free is useful for models that are not actively traded, based on the price of more liquid securities. These models are "potentially superior" due to their basis in economic financial reasoning.
Major drawback is that they depend crucially on the validity of the assumptions built into the models.
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What is the Vasicek model
where theta denotes the long-run value or central tendency of the short-term rate in the risk-neutral process and the positive constant, k, denotes the speed of the mean reversion.
The great the difference between r and theta, the greated the expected change in the short-term rate toward theta.
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