Explanation:
The Cox-Ingersoll-Ross (CIR) model incorporates mean reversion and accounts for the fact that interest rates cannot be negative. The model takes the form dr = a(b-r)dt + σ√r dz. In this model, the volatility of the short-term interest rate is explicitly proportional to the square root of the rate (σ√r).
In contrast, the Ho-Lee model has a time-dependent (not constant) drift term and does not incorporate mean reversion.
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Q.14 A hedge fund's Chief Risk Officer (CRO) has tasked the risk management team with developing a term-structure model to fit interest rates for the fund's options pricing practices. The team is considering two models: a Ho-Lee model and a Cox-Ingersoll-Ross (CIR) model. Which of the following statements correctly describes a characteristic of these models?
A
In the Ho-Lee model, the interest rate process includes a constant drift term.
B
In the Ho-Lee model, the drift term is adjusted to ensure the interest rate reverts to a long-run mean.
C
In the CIR model, the volatility of the short-term interest rate is presumed to decline exponentially to a constant long-run level.
D
In the CIR model, the volatility of the short-term interest rate is proportional to the square root of the rate.
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