Consider a Two-Factor HJM Model Where the Initial Forward Curve $T$

Consider a two-factor HJM model where the initial forward curve is given as 6% for one year and 7% between one and two years. The evolution of continuously-compounded one-year forward rates beginning at time $T$ , is given by the following binomial process with two shock terms: $f ( t + 1 , T ) = f ( t , T ) + \alpha \pm 0.01 \pm 0.01$ , where the forward rate movements are equiprobable. What this means is that the forward rate may move up by either 0.02 with probability 1/4, or move down by 0.02 with probability 1/4, or remain the same with probability 1/2. What is the risk-neutral drift ( $\alpha$ ) for $f ( 1,1 )$ ?

A) $- 0.0002$
B) $- 0.0001$
C) $+ 0.0001$
D) $+ 0.0002$

Correct Answer:

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