Vasicek Model and Mean Reversion of Interest Rates

Hard Term Structure Dynamics Interest Rate Models

Consider the Vasicek interest rate model, which is widely used to describe the evolution of interest rates over time. The model is characterized by the mean reversion behavior of interest rates, which suggests that rates tend to drift towards a long-term average. Given a scenario where the short-term interest rate increases significantly due to a sudden economic shock, how would the Vasicek model predict the future path of interest rates in the short to medium term?

Which of the following statements best describes the predicted behavior of the interest rate in the context of the Vasicek model?

The interest rate will continue to rise indefinitely as it is now above the long-term mean.

The interest rate will decrease towards the long-term mean, demonstrating mean-reverting behavior.

The interest rate will stay constant at its current level since economic shocks have no long-term effects.

Hint

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