On non-existence of a one factor interest rate model for volatility averaged generalized Fong-Vasicek term structures

TL;DR

This paper proves that a one-factor interest rate model cannot replicate the bond prices derived from a two-factor generalized Fong--Vasicek model with stochastic volatility, highlighting the complexity of modeling interest rate volatility.

Contribution

It demonstrates the non-existence of a one-factor model that matches the averaged bond prices of a two-factor stochastic volatility model.

Findings

No one-factor model can replicate the averaged bond prices from the two-factor model.

Averaged bond prices depend on current short rate similar to simpler models.

The result emphasizes the necessity of multi-factor models for accurate interest rate volatility modeling.

Abstract

The purpose of this paper is to study the generalized Fong--Vasicek two-factor interest rate model with stochastic volatility. In this model the dispersion of the stochastic short rate (square of volatility) is assumed to be stochastic as well and it follows a non-negative process with volatility proportional to the square root of dispersion. The drift of the stochastic process for the dispersion is assumed to be in a rather general form including, in particular, linear function having one root (yielding the original Fong--Vasicek model or a cubic like function having three roots (yielding a generalized Fong--Vasicek model for description of the volatility clustering). We consider averaged bond prices with respect to the limiting distribution of stochastic dispersion. The averaged bond prices depend on time and current level of the short rate like it is the case in many popular one-factor interest rate model including in particular the Vasicek and Cox--Ingersoll-Ross model. However, as a main result of this paper we show that there is no such one-factor model yielding the same bond prices as the averaged values described above.