The previous example assumes that the risk-free rate is constant. An alternative, perhaps more plausible, model might

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The previous example assumes that the risk-free rate is constant. An alternative, perhaps more plausible, model might be to assume that the risk-free rate is mean reverting, with a long-run mean. Under this assumption, if the current rate is above the long-run mean, the next period rate will tend downward, and vice versa. One such model is the Ornstein-Uhlenbeck process:

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Simulate this process over 12 months:

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Financial Modeling

ISBN: 9780262027281

4th Edition

Authors: Simon Benninga

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