Constructing Binomial Models for the Short Rate

©Finbarr Murphy 2007

 P(i) = price at time t=0 of a pure discount bond maturing at iΔt

Qi ,i  12 Qi 1,i 1d i 1,i 1

Qi ,  i  12 Qi 1,  i 1d i 1,  i 1
Qi , j  12 Qi 1, j 1d i 1, j 1  12 Qi 1, j 1d i 1, j 1
 the BDT90 process becomes (const volatility)

d ln r (t )    t  dt  dz
ri , j  U  i  e
COMPUTATIONAL FINANCE

j t

1
di , j 
1  ri , j t
P i  1   Q di, j i, j
j
MSc

1
 Constructing Binomial Models for the Short RateP(3) = 0.8638 ©Finbarr Murphy 2007

P(2) = 0.9070
P(1) = 0.9524
U(1) = 0.498

Q0,0 = 1 Q1,1 = 0.4762

r0,0 = 0.05 r1,1 = 0.055
d0,0 = 0.9524 d1,1 = 0.9479
P(0) = 1

Q1,1 = 0.4762
r1,1 = 0.045
d1,1 = 0.9569
We can
 Now say
repeat
thatnow
calculate
to Calculate Q1,1for subsequent
and Q1,-1 values.
 Q 0,0 == 0.055
r1,1 1
1/2Q andd0,0r1,-1 = 0.045
= 0.4762
COMPUTATIONAL FINANCE

1,1 0,0
 Remember that the outer states are treated a little
rd0,0
 Q 1,-1=
1,1 ==0.05
0.9479
1/2Q0,0and
d0,0 d=1,-1 = 0.569
0.4762
differently from the inner states.
 d0,0 = 1/(1+0.05∆t) = 0.9524 1
1
 Solve
P i  1  P (2)   0.9070  Q d
1, j 1, j
(1  0.05) 2
j  1
1
1
  Q1, j

1  U (i ) exp j t t 
MSc

j  1 2