CT 8 CHAP 17

in section 6 "Limitations of one-factor models" of chapter 17 in CT8 THere is a PARagraph under 'LIMITATIONS' heading which is as follows-

" Third, we need more complex models to deal effectively with derivative contracts that are more complex than, say, standard European call options. For example, any contract that makes reference to more than one interest rate should allow these rates to be less than perfectly correlated. "
(This paragraph is pointing out the limitation of using one factor models for interest rates)

so,can anybody please explain this paragraph, it will be of great help. thanks

 

Many complex derivative contracts exist in the real world that, happily enough, we don't need to study in CT8.

This paragraph is saying that if we had a contract based on two interest rates - say the 5-year spot rate and the 10-year spot rate - then to price that appropriately, we need a model for interest rates in which movements in the two rates are not perfectly correlated. That's because, in reality, it's quite possible for the 5-year spot rate to increase at the same time that the 10-year spot rate decreases.

 

That was really simple . i think i was using my head more than it was required ,anyways , Thank u sir for always guiding us

 

today the results came out and i cleared the exam,Mark sir it was your guidance and support which helped me a lot in clearing the exam. Thank you very much sir.

 

Congratulations!

 

thank you sir