Vasicek Interest Rate Model

The Vasicek interest rate model is a mathematical model that attempts to predict interest rate movements based on market risk, equilibrium value, and time. Welcome to the Twilight Zone.

The model assumes that interest rates will always revert towards the mean value of its past values in the long-run. That’s quite the assumption to make. But there are lots of assumptions like this in statistics, and they seem magical, but they've been proven to work remarkably well. In addition, this assumption is always changing, as new prices are constantly being added to, and changing, the equilibrium in the equation.

Plus, it takes into account other factors, like current market volatility in the economy, so it’s not calculating interest rates in a vacuum. Of course, calculating this risk can be tricky on its own. Typically, the market risk is calculated using the Wiener process, a way of estimating random market risk at any given time period. Rather than being hyper-specific, the Vasicek interest rate model is used to make educated guesses about which way an interest rate may be expected to go.

This model hit a speed bump during the 2007 financial crisis: it can’t model for interest rates less than zero. Newer models, like exponential Vasicek model and the Cox-Ingersoll-Ross model, are based off the OG Vasicek interest rate model, adapting it to be a bit more flexible for times when below-zero interest rates are happening.