Explain the mean reversion property found in an interest-rate model
What will be an ideal response?
By the mean reversion property, it is meant that some long-run stable mean value for the short rate is assumed. This long-run value can be denoted by . So, if the short-rate (r) is greater than , the direction of change in the short rate will move down in the direction of the long-run stable value and vice versa. However, in specifying the mean reversion process, it is necessary to indicate the speed at which the short rate will move or converge to the long-run stable mean value. This parameter is called the speed of adjustment and can be denoted by α. The mean reversion process that specifies the dynamics of the drift term is given as b(r,t) = ?α(r – ) where b is the drift term (discussed previously).
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