Explanation:
The Vasicek model is a one-factor short rate model that assumes interest rates are mean-reverting and follow a normal distribution. While the model is mathematically tractable, its reliance on a normal distribution implies that interest rates can become negative. Additionally, as a one-factor model, it does not always accurately capture the term structure of interest rates or complex term structure dynamics, especially during periods of high market volatility. Therefore, option C correctly describes both its assumptions (mean reversion and normal distribution) and its limitations regarding term structure in volatile markets.
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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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