What Is the Vasicek Interest Rate Model?
The Vasicek interest rate model (or simply the Vasicek model) is a mathematical method of modeling interest rate movements based on market risk, time, and long-term equilibrium interest rate values.
- The Vasicek model 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.
- The model is often used in the valuation of interest rate futures and in solving for the price of various hard-to-value bonds.
- The main drawback of the Vasicek model is that it does not allow for the interest rate to dip below zero.
The Vasicek Interest Rate Model Formula
The Vasicek interest rate model values the instantaneous interest rate using the following equation:
drt=a(b−rt)dt+σdWtwhere:W=Random market risk (represented bya Wiener process)t=Time perioda(b−rt)=Expected change in the interest rateat time t (the drift factor)a=Speed of the reversion to the meanb=Long-term level of the meanσ=Volatility at time t
The model specifies that the instantaneous interest rate follows the stochastic differential equation, where d refers to the derivative of the variable following it.
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, which indicates that the interest rate will increase toward equilibrium.
The Vasicek model states that the movement of interest rates is affected only by random (stochastic) market movements.
Understanding the Vasicek Interest Rate Model
The Vasicek interest rate model is employed in financial economics to estimate potential pathways for future interest rate changes.
The model describes the movement of an interest rate as a factor composed of market risk, time, and equilibrium value, with the rate tending to revert toward the mean of those factors over time. 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.
The equation can only test one market risk factor at a time.
Limitations of the Vasicek Interest Rate Model
Although it was considered to be a great step forward in predictive financial equations, the main drawback of the Vasicek model that has come to light since the global financial crisis of the late 2000s is that it does not allow for the interest rate 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.