Question #2

of 34 Jill Sebelius, editor-in-chief of a monthly interest-rate newsletter uses the following model to forecast short-term interest rates: For the current newsletter, Sebelius has issued the following expectations: a=0.40, b = 3%, r = 2%. According to the model used by Sebelius, volatility in the short-term in interest rate is most likely: A) independent of the current level of the short-term interest rate. B) negatively related to the current level of the short-term interest rate. C) positively related to the current level of the short-term interest rate. Dan Laske, CFA, recently joined Axes Bank as a bond trader. Laske is reviewing bank's interest rate models and meets with Sheila Jensen, a senior portfolio manager at the bank. Jensen makes the following statements: Statement 1: I don't want any random noise in the short-term rate forecasts. Statement 2: I like interest models to incorporate mean reversion of rates. Statement 3: I prefer that the interest rate volatility varies with the level of interest rates. Laske finally decides on using the Gauss+ model and asks Jensen about her opinion. Jensen makes the following observations about the Gauss+ model: Observation 1: Gauss+ models are primarily used for forecasting long-term rates, while equilibrium models are used for short-term rates. Observation 2: Gauss+ models assume that the long-term rates are mean reverting, while the central bank actions determine the short-term rates. dr = a(b −r) dt + σ√rdz