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. Compare this to a one-factor HJM model where $f ( t + 1 , T ) = f ( t , T ) + \alpha \pm 0.02$ . Which of the following statements is most valid?

A) ATMF bond option prices will be higher in the one-factor model.
B) ATMF bond option prices will be lower in the one-factor model.
C) ATMF bond option prices will be equal in the one- and two-factor models.
D) There is insufficient information to determine the answer.

Correct Answer:

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