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Answer: When short-term rates are negative, the risk manager sets the rate to zero.
## Explanation When dealing with negative interest rates in interest rate models, the most practical and commonly used approach is: - **Option D**: Setting negative rates to zero is the most appropriate action. This approach recognizes that while negative rates can occur in models, in practice, rates typically have a lower bound of zero (or slightly negative in some modern contexts). Setting negative rates to zero prevents unrealistic scenarios and maintains model stability. Let's evaluate the other options: - **Option A**: Using a normal distribution actually increases the likelihood of negative rates, as normal distributions have unbounded support. - **Option B**: Adjusting risk-neutral probabilities is complex and may not directly address the negative rate issue. - **Option C**: Increasing volatility when rates are negative would exacerbate the problem rather than solve it. Therefore, option D represents the best practice for handling negative interest rates in pricing models.
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Q-79. A risk manager is pricing a 10-year Treasuries using a successfully tested pricing model. Current interest rate volatility is high and the risk manager is concerned about the effect this may have on short-term rates when pricing the option. Which of the following actions would best address the potential for negative short-term interest rates to arise in the model?
A
The risk manager uses a normal distribution of interest rates.
B
When short-term rates are negative, the risk manager adjusts the risk-neutral probabilities.
C
When short-term rates are negative, the risk manager increases the volatility.
D
When short-term rates are negative, the risk manager sets the rate to zero.