Explanation:
The Vasicek model operates on the assumption that interest rates follow a mean-reverting process and have a normal distribution, which inherently implies that rates can theoretically become negative. While it is useful for basic term structure modeling, its limitation of constant volatility means it often struggles to accurately capture the complexities of the term structure of interest rates, especially during periods of high market volatility. Therefore, statement C provides the best description of its assumptions and limitations.
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Q.5301 In the context of the Vasicek Model for interest rate changes, which of the following statements best describes the model's assumptions and limitations?
A
The model assumes that interest rates follow a mean-reverting process, with no consideration for market factors or the term structure of interest rates.
B
The model assumes that interest rates follow a normal distribution and mean reversion is constant across different market conditions.
C
The model assumes that interest rates are mean-reverting and normally distributed. However, it may not accurately capture the term structure of interest rates during periods of high market volatility.
D
The model assumes that interest rates follow a mean-reverting process. Besides, it accurately captures the interest rates term structure, even during high market volatility periods.
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