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

question 6

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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Definitions:

Variable Costs

Financial outlays that directly correspond to the volume of production or sales, encompassing costs for raw materials and direct labor.

Sales

The transactions involving the exchange of goods or services for money, forming the revenue of a company.

Units

Units refer to the individual components or elements that can be counted or measured, often used in the context of production, sales, and inventory.

Margin Of Safety

The difference between actual sales and break-even sales, indicating how much sales can fall before a business incurs a loss.