Explanation:
The correct answer is B.
The Vasicek model, which is a type of one-factor model, is used to describe the evolution of interest rates. Under the Vasicek model with mean reversion, a positive shock to the short-term interest rate factor (an increase of 10 basis points) will instantly drive up the short-term rate by the same 10 basis points. However, because of the mean reversion mechanism in the model, the expectation is that rates will be pulled back towards a long-term average over time. Consequently, the effect of the immediate short-rate shock dampens as maturity extends. This means that longer-term spot rates are impacted, but by an amount less than the full 10 basis points.
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Q.1668 An analyst draws a graph showing the effects of spot rates using the Vasicek model having a 10-basis-points change in the factor. The graph interprets how the 10 basis point change in short-term rate affects the spot rate curve. The model is graphed with mean reversion. What would be the effect on long-term and short-term rates given an increase of 10 basis points in the interest rate factor?
A
The short-term rates decrease by about 10 basis points but longer-term rates are less impacted.
B
The short-term rates increase by about 10 basis points but longer-term rates are less impacted.
C
The short-term rates increase by about 10 basis points but longer-term rates are impacted by more than 10 basis points.
D
The short-term rates, as well as long-term rates, increase by 10 basis points because of the increase in volatility.
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