We have assumed the short-term interest rate has a lognormal distribution at any time horizon. This means we require only a mean and standard deviation to fully specify its distribution. However, in the BK model, three factors are required to describe the short-term interest rate process - the target rate, mean reversion speed and local volatility. This means that for a given time horizon, the solution is not unique and the distribution of short- term interest rates may be matched by a family of possible processes.

These processes will differ in their mean reversion and local volatility characteristics. Strong mean reversion means a move away from the target rate is quickly reversed , which is not the case for weaker mean reversion. Hence, a narrow (wide) distribution of the short-term interest rate in the future may result from either strong (weak) mean reversion or low (high) local volatility.

Interest Rate Modelling (Finance and Capital Markets Series)

ISBN: 1403934703

EAN: 2147483647

EAN: 2147483647

Year: 2004

Pages: 132

Pages: 132

Authors: Simona Svoboda

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