What is meant by a lognormal model of interest rates?
What will be an ideal response?
Like a normal model, the classification of a model as lognormal is based on the assumed dynamics of the random component of the SDE. However, unlike normal models, lognormal models assume that interest-rate volatility is proportional to the level of rates, and therefore negative interest rates are not possible. An example of a lognormal model is the
Kalotay-Williams-Fabozzi (KWF) model where changes in the short-rate are modeled by modeling the natural logarithm of r; no allowance for mean reversion is considered in the model.
Empirical evidence regarding the relationship between interest-rate volatility and the level of rates suggests that the relationship is weak at interest rate levels below 10%. However, for rates exceeding 10%, there tends to be a positive relationship. This evidence suggests that in rate environments below 10%, a normal model would be more descriptive of the behavior of interest rates than the lognormal model. Moreover, empirical tests suggest that the impact of negative interest rates on pricing is minimal, and therefore one should not be overly concerned that
a normal model admits the possibility of negative interest rates.
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