Consider a Two-Factor HJM Model Where the Initial Forward Curve $T$

question 8

Multiple Choice

Consider a two-factor HJM model where the initial forward curve is given as 6% for one year and 7% between one and two years.The evolution of continuously-compounded one-year forward rates beginning at time $T$ ,is given by the following binomial process with two shock terms: $f ( t + 1 , T ) = f ( t , T ) + \alpha \pm 0.01 \pm 0.01$ ,where the forward rate movements are equiprobable.Compare this to a one-factor HJM model where $$f ( t + 1 , T ) = f ( t , T ) + \alpha \pm 0.02$$ .Which of the following statements is most valid?

• A)ATMF bond option prices will be higher in the one-factor model.
• B)ATMF bond option prices will be lower in the one-factor model.
• C)ATMF bond option prices will be equal in the one- and two-factor models.
• D)There is insufficient information to determine the answer.

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