What is the 'Vasicek Interest Rate Model'

The Vasicek interest rate model is a method of modeling interest rate movement that describes the movement of an interest rate as a factor of market risk, time and equilibrium value that the rate tends to revert towards. Essentially, it predicts where interest rates will end up at the end of a given period of time given current market volatility, the long-run mean interest rate value, and a given market risk factor. It is important to note that the equation can only test one market risk factor at a time. This stochastic model is often used in the valuation of interest rate futures.

The Vasicek interest rate model values the instantaneous interest rate using the following equation:

drt = a(b-rt)dt +sdWt

Wt is the random market risk (represented by the Wiener process)
t represents time
a(b-rt) represents the expected change in the interest rate at t (drift factor)
a is the speed of reversion
b is the long-term level of the mean
s is the volatility at the time

Next Up

BREAKING DOWN 'Vasicek Interest Rate Model'

The Vasicek interest rate model states that the movement of interest rates is affected only by random market movements. In the absence of market shocks (i.e., when dWt = 0) the interest rate remains constant (rt = b). When rt < b, the drift factor becomes positive, it indicates that the interest rate will increase toward equilibrium. Although it was a great step forward in predictive equations, the main drawback of the model that has come to light since the global financial crisis is that the Vasicek model does not allow interest rates to dip below zero. This issue has been fixed in several models that have been developed since the Vasicek model such as the exponential Vasicek model and the Cox-Ingersoll-Ross model.

RELATED TERMS
1. Fed Model

The Fed model is a tool used to determine whether the U.S. stock ...

A business model is a company's plan for generating revenues ...
3. Interest Rate Call Option

An interest rate derivative in which the holder has the right ...
4. Multistage Dividend Discount Model

The multistage dividend discount model is an equity valuation ...
5. Stochastic Volatility - SV

Stochastic volatility refers to the fact that the volatility ...
6. Multi-Factor Model

A multi-factor model uses many factors in its computations to ...
Related Articles

Calculating (Small) Company Credit Risk

Determining creditworthiness of smaller and medium-sized corporations isn't as easy as for larger companies, but these tips can help.
2. Insights

10 Countries With Lower Interest Rates Than the US

Learn about the 10 countries with lower interest rates than the United States and how interest rates indicate a country's economic outlook.
3. Investing

Financial Models You Can Create With Excel

The relatively modest amount of time it takes to build these models can pay for itself by leading you to better investment decisions.
4. Personal Finance

Discounted cash flows or comparables: Which to use

DCF and comparables models are widely used in equity valuation, and here we'll explain the pros and cons of each method.
5. Investing

How Do Interest Rates Affect the Stock Market?

Interest rates can have a complicated ripple effect through financial markets. Here's what you need to know.
6. Insights

When Will Interest Rates Rise?

Find out if -- and why -- the Federal Reserve will keep raising interest rates and what that might mean for savers, investors and the entire economy.
7. Insights

The Fed Model And Stock Valuation: What It Does And Does Not Tell Us

Learn about this popular stock market valuation model and how accurate it has been over the years.
8. Investing

How Interest Rates Affect Mutual Funds

Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
9. Investing

More Model 3 Details Emerge on Tesla Earnings Call

Tesla said the Model 3 will have fewer "bells and whistles" but a more automated production process to enable scale.
10. Investing

How Rising Rates Impact Investment Strategies

Interest rates are on the rise. Here's what that means for investing strategies.
RELATED FAQS
1. What is the difference between financial forecasting and financial modeling?

Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
2. What is the Difference Between Real and Nominal Interest Rates?

Learn about nominal interest rates and real interest rates and the difference between the two (hint: one of them takes into ... Read Answer >>
3. How do national interest rates affect a currency's value and exchange rate?

Generally, higher interest rates increase the value of a given country's currency, but Interest rates alone do not determine ... Read Answer >>
4. How accurate is the forward rate in predicting interest rates?

Find out why forward rates are inconsistent and limited predictors of actual future interest rates, primarily because the ... Read Answer >>
Hot Definitions
1. Working Capital

Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
2. Bond

A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
3. Compound Annual Growth Rate - CAGR

The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
4. Net Present Value - NPV

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
5. Price-Earnings Ratio - P/E Ratio

The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
6. Internal Rate of Return - IRR

Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.