Vasicek model is a model used in finance that depicts the development, movement or evolution of interest rates. The model is based on one single factor or source of market risk but it is useful in evaluating the pricing of derivatives or interest rates. Developed in 1977 by Oldrich Vasicek, the model also has a function in stochastic charting (Vasicek, 1977). Vasicek himself characterized it as an equilibrium within the term structure.
The formula for the model is and shows that stochastic differential equation gives place to the instant interest rate. It is the parameter of the standard deviation that allows for volatility to be determined (James, Webber, 2000).
Vasicek (1977) notes that a number of assumptions are at play in this formula -- such as the idea that spot interest "follows a diffusion process" and that it is on the spot rate that "discount bond" prices are dependent; the final assumption that "the market is efficient" (p. 177) is perhaps the most dangerous one -- or the one that applies least in today's market of dark pools, high-frequency traders, spoofing, and market manipulation. One must have a sense of how different today's market is from Vasicek's of nearly forty years ago. The mathematics may not have changed, but the assumptions need to be updated.
The context for which the model was created was the notion that interest rates cannot go up or down forever and will in the long run, or over time, proceed within a limited range. There is a "drift factor" along with the long-term equilibrium parameter that is meant to serve as the bar to which interest rates return -- but in today's world of "artificially low" interest rates, this bar may be subject...
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