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Hi David,

I have a question about the Vasicek Model. I have seen a couple of practice questions come up (not BT questions) where the volatility adjustment is ignored when determine the future rate. For reference let me post some details of the question I just saw today:

-mean reversion parameter of 0.05

-annual standard deviation of 125 basis points

-a true long term interest rate of 3%

-annual interest rate drift of 0.45%

-current interest rate of 6%

Using the Vasicek model estimate the foretasted change in the short term rate for the next month

The solution given is:

True long term mean = .03+(.45%/.05) = .12

so rate change = .05*(.12-.06)*(1/12) = 0.025%

I am wondering why there is no volatility adjustment here? I know for the Vasicek model if we are forcing the middle node to recombine we can ignore the volatility adjustment, but nothing in the question indicates that's what we're doing here. As I said this is the 2nd time I've come across this method, have I missed something in the reading? Or is this just a mistake and a volatility adjustment should apply?

Thanks for your insights!

I have a question about the Vasicek Model. I have seen a couple of practice questions come up (not BT questions) where the volatility adjustment is ignored when determine the future rate. For reference let me post some details of the question I just saw today:

-mean reversion parameter of 0.05

-annual standard deviation of 125 basis points

-a true long term interest rate of 3%

-annual interest rate drift of 0.45%

-current interest rate of 6%

Using the Vasicek model estimate the foretasted change in the short term rate for the next month

The solution given is:

True long term mean = .03+(.45%/.05) = .12

so rate change = .05*(.12-.06)*(1/12) = 0.025%

I am wondering why there is no volatility adjustment here? I know for the Vasicek model if we are forcing the middle node to recombine we can ignore the volatility adjustment, but nothing in the question indicates that's what we're doing here. As I said this is the 2nd time I've come across this method, have I missed something in the reading? Or is this just a mistake and a volatility adjustment should apply?

Thanks for your insights!

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