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Answer: Model 1 implies a term structure that is perfectly flat at the current rate for all maturities, including the long-term rates.
## Explanation **Model 1 (No-drift model)** assumes zero drift and is also called a normal model. **Model 2** adds a drift term. Let's analyze each option: - **A**: Correct - Model 1 can produce negative interest rates, which is indeed a weakness. - **B**: **INCORRECT** - Model 1 does NOT imply a perfectly flat term structure for all maturities. While it assumes no drift, the term structure is not necessarily flat across all maturities. The statement is inaccurate. - **C**: Correct - Model 2 with drift is more capable of producing upward-sloping term structures, which are commonly observed in real markets. - **D**: Correct - Model 2 is an equilibrium model that doesn't attempt to match the current term structure exactly, making it different from arbitrage-free models. The question asks for the statement that is NOT true, which is option B.
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Q-78. Model 1 assumes zero drift and is also called a normal model. Model 2 adds a term for drift. Each of the following is true about these two models except for:
A
A weakness of Model 1 is that the short-term rate can become negative.
B
Model 1 implies a term structure that is perfectly flat at the current rate for all maturities, including the long-term rates.
C
Model 2 is more capable of producing an upward-sloping term structure, which is often observed.
D
Model 2 is an equilibrium model, rather than an arbitrage-free model, because no attempt is made to match the term structure closely.