VASCIEK Model

[Bilal Ehsan]

Dear David,

There was question in the exam asking for shape of curve in third year of Note...Values were given Long run means=8% , Mean reversion parameter=0.02 , current short term rate 5% and 1% Volatility...Question asked for the shape of the curve 1. Upward, 2 Downward, 3 Flat or Humped...Can you tell us how can we identify the shape as on year 3 wer will have upper, middle and dowward node...

 

[jaivipin]

Is that the answer upward ?

 

[jaivipin]

Good notes related to this from Schweser :

Consider an upward shift in the short-term rate. In the mean-reverting
model, the short-term rate will be impacted more than long-term rates. Therefore, the
Vasicek model does not imply parallel shifts from exogenous liquidity shocks. Another
interpretation concerns the nature of the shock. If the shock is based on short-term
economic news, then the mean reversion model implies the shock dissipates as it approaches
the long-run mean. The larger the mean reversion parameter, the quicker the economic
news is incorporated. Similarly, the smaller the mean reversion parameter, the longer it takes
for the economic news to be assimilated into security prices. In this case, the economic news
is long-lived. In contrast, shocks to short-term rates in models without drift affect all rates
equally regardless of maturity (i.e., produce a parallel shift)