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Answer: In the CIR model, yield volatility is specified as being constant while basis-point volatility is allowed to vary.
Explanation C is correct. In the Cox-Ingersoll-Ross (CIR) model, basis-point volatility is a function of the yield volatility, which is assumed to be constant and the square root of the short rate. Therefore, by assumption, yield volatility is constant and basis-point volatility varies. Option A is incorrect because the CIR model states that when short-term interest rates are very low, basis-point volatility will also be very low, which decreases the possibility of negative interest rates. This possibility can be removed entirely if a positive drift factor that is larger than the impact of volatility is included in the model. Option B is incorrect as in the CIR model, basis-point volatility is specified as an increasing function of the short rate. Option D is incorrect because basis-point volatility and yield volatility are measured in different units, but they do not measure the same volatility in the CIR model.
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A
Periods of extremely low short-term interest rates are accompanied by high basis point volatility, which increases the possibility of negative interest rates in the CiR model.
B
In the CiR model, basis-point volatility is specified as a decreasing function of the mean reversion factor.
C
In the CIR model, yield volatility is specified as being constant while basis-point volatility is allowed to vary.
D
Basis-point volatility and yield volatility are used interchangeably to measure the same volatility in the CiR model.
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