easy · FRM Part 2 Market Risk
A risk practitioner is analyzing the term structure of interest rates using the Vasicek and Cox-Ingersoll-Ross (CIR) models.
What is the fundamental difference in how these models handle the volatility of the short rate dr_t?
- Vasicek uses a Binomial Tree to price options, while CIR requires a Monte Carlo simulation due to its non-parametric nature.
- CIR is a 'Reduced-Form' model for credit spreads, while Vasicek is a 'Structural' model for the risk-free rate.
- Vasicek assumes mean reversion to a time-varying drift θ(t), whereas CIR only allows for mean reversion to a constant long-term mean.
- In Vasicek, volatility σ is constant; in CIR, volatility is σ √(r_t), preventing interest rates from becoming negative.
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