Vasicek Interest Rate Model

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 Interest Rate Model Formula

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

d r t = a ( b − r t ) d t + σ d W t where: W = Random market risk (represented by a Wiener process) t = Time period a ( b − r t ) = Expected change in the interest rate at time  t  (the drift factor) a = Speed of the reversion to the mean b = Long-term level of the mean σ = Volatility at time  t \begin{aligned} &dr_t = a ( b - r^t ) dt + \sigma dW_t \\ &\textbf{where:} \\ &W = \text{Random market risk (represented by}\\ &\text{a Wiener process)} \\ &t = \text{Time period} \\ &a(b-r^t) = \text{Expected change in the interest rate} \\ &\text{at time } t \text{ (the drift factor)} \\ &a = \text{Speed of the reversion to the mean} \\ &b = \text{Long-term level of the mean} \\ &\sigma = \text{Volatility at time } t \\ \end{aligned} 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 _d_Wt = 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.

This stochastic model is often used in the valuation of interest rate futures and is sometimes used in solving for the price of various hard-to-value bonds.

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.