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1
CopyrightJohnHull.AllRightsReserved.ThisnotemaybereproducedforuseinconjunctionwithOptions,
Futures,andOtherDerivativesbyJohnC.Hull
2
SeeF.Black,E.Derman,andW.Toy,``AonefactormodelofinterestratesanditsapplicationtoTreasurybond
options,FinancialAnalystsJournal,46(1),3339.
2
t
d
r
A
+ ) 1 (
1
The value of the bond at node C is
t
u
r
A
+ ) 1 (
1
It follows that the value of the bond at the initial node A is
(
(
+
+
+ +
A A A t
u
t
d
t
r r r ) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
Hence
t t
u
t
d
t
R r r r
A A A A
+
=
(
(
+
+
+ +
2
2
) 1 (
1
) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
(1)
Figure 1 The Binomial Tree
r
r
u
r
d
r
uu
r
ud
r
dd
r
uuu
r
uud
r
udd
r
ddd
A
B
C
D
E
F
3
This is one equation that must be satisfied by r
u
and r
d
. To match the volatility, the standard deviation of
the logarithm of the interest rate at time At must be t A o
1
(Recall: o
i
is the volatility of interest rates
during the ith time period.) This means that
3
t
r
r
d
u
A o =
1
ln 5 . 0 (2)
Equations (1) and (2) can be solved to determine r
u
and r
d
.
We now move on to determine r
uu
, r
ud
and r
dd
. To match volatility we must have
t
r
r
ud
uu
A o =
2
ln 5 . 0 (3)
t
r
r
dd
ud
A o =
2
ln 5 . 0 (4)
We must also match the price of a zero-coupon bond that pays off $1 at the end of time 3At. Rolling back
through the tree the values of this bond at nodes D, E, and F are
t
uu
t
ud
t
dd
r r r
A A A
+ + + ) 1 (
1
,
) 1 (
1
,
) 1 (
1
and
respectively. The values at nodes B and C are
(
(
+
+
+ +
A A A t
ud
t
dd
t
d
r r r ) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
and
(
(
+
+
+ +
A A A t
uu
t
ud
t
u
r r r ) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
The value at the initial node is therefore
3
To see this note that the variance of the logarithm of the interest rate is
0.5(ln r
u
)
2
+0.5(ln r
d
)
2
[0.5(ln r
u
+ln r
d
)]
2
=[0.5(ln r
u
ln r
d
)]
2
t t
uu
t
ud
t
u
t
t
ud
t
dd
t
d
t
R r r r r
r r r r
A A A A A
A A A A
+
=
|
|
.
|
\
|
(
(
+
+
+ + +
+
|
|
.
|
\
|
(
(
+
+
+ + +
3
3
) 1 (
1
) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
5 . 0
) 1 (
1
(5)
The interest rates r, r
u
and r
d
have already been determined. Equations (3), (4), and (5) therefore provide
three equations for determining r
uu
, r
ud
, and r
dd
.
Continuing in this way a complete tree can be constructed. The calculations are made considerably easier
if as we move forward we keep track of the value of a security that pays $1 if a particular node is reached
and zero elsewhere. It is then only necessary to roll back one step when valuing zero-coupon bonds using
the tree.
Determining the o
i
The determination of the o
i
depends on the data available. Sometimes the historical volatilities of zero-
coupon bond yields are used; sometimes the volatilities of caps or swaptions are used. An iterative search
procedure is always necessary.
When bond yields are being matched, we assume that we have data at time zero on the volatilities of a
bond maturing at time iAt. We will denote this by |
i
. (We approximate |
i
as the volatility of this bond
yield between time zero and time At.) We denote y
un
as the yield on a bond maturing at time nAt at node
C and y
dn
as the yield on a bond maturing at time nAt at node B. Considering a bond that matures at time
2At,
2
2
2
ln 5 . 0
d
u
y
y
t = A |
Because there is only one period left in the bond's life at the nodes at time At, y
u2
= r
u
and y
d2
= r
d
. As a
result
d
u
r
r
t ln 5 . 0
2
= A |
Using equation (2) leads to
o
1
= |
2
The interest rates r
u
and r
d
can then be determined from equations (1) and (2).
Determining the subsequent o
i
requires an iterative search. For example, to determine o
2
3
3
3
ln 5 . 0
d
u
y
y
t = A |
5
This must be solved iteratively with equations (3), (4), and (5) for o
2,
r
uu
, r
ud
, and r
dd
.
In general the procedure to determine o
i
(i > 1) is
1. Choose a trial value of o
i
2. Calculate the interest rates at time iAt
3. Calculate the yield volatility for a bond lasting until iAt from the tree. This involves calculating
the bond yields y
u
and y
d
at nodes B and C. The bond yield volatility is 0.5ln(y
u
/y
d
)
4. Search iteratively for the value of o
i
that matches the bond yield volatility
Once the tree has been constructed it can be used to value a range of interest rate derivatives.
Example
As an example of the application of the model suppose that the term structure of interest rates is as shown
in Table 1, the zero-coupon yield volatilities are as shown in Table 2, and the time step is one year. In this
case r=0.10, At=1, o
1
=0.19 (the two-year yield volatility) and equations (1) and (2) give
19 . 0 ln 5 . 0
11 . 1
1
1
1
5 . 0
1
1
5 . 0
10 . 1
1
2
=
=
(
+
+
+
d
u
u d
r
r
r r
Solving these two equations gives r
u
= 0.1432 and r
d
= 0.0979.
Table 1
Zero-coupon Yield Curve (Annually Compounded)
Maturity (years) Rate
1 10.0
2 11.0
3 12.0
4 12.5
5 13.0
6
Table 2
Yield Volatilities
i |
i
2 19.0%
3 18.0%
4 17.5%
5 16.0%
Equations (3), (4), and (5) give
2
ln 5 . 0 o =
ud
uu
r
r
2
ln 5 . 0 o =
dd
ud
r
r
3
12 . 1
1
1
1
5 . 0
1
1
5 . 0
1432 . 1
1
5 . 0
1 . 1
1
1
1
5 . 0
1
1
5 . 0
0979 . 1
1
5 . 0
1 . 1
1
=
|
|
.
|
\
|
(
+
+
+
+
|
|
.
|
\
|
(
+
+
+
uu ud
ud dd
r r
r r
We do not know o
2
directly. For each trial value of o
2
we solve equations (3), (4), and (5) and then
calculate the price of a three-year bond at nodes B and C. The price of a three-year bond at node B is
(
+
+
+
=
ud dd
d
r r
B
1
1
5 . 0
1
1
5 . 0
0979 . 1
1
and the bond yield at node B is
1
1
=
d
d
B
y
The price of a three-year bond at node C is
(
+
+
+
=
uu ud
u
r r
B
1
1
5 . 0
1
1
5 . 0
1432 . 1
1
The bond yield is
1
1
=
u
u
B
y
7
Carrying out an iterative search we find that o
2
= 0.172 does the trick. With this value of o
2
the solutions
to the three equations are
r
uu
= 0.1942
r
ud
= 0.1377
r
dd
= 0.0976
These in turn give B
u
= 0.7507, B
d
= 0.8152, y
u
= 0.1542, and y
d
= 0.1076. Because 0.5ln(0.1542/0.1076)
= 0.18 the three-year yield volatility is matched.
The complete tree of short rates is shown in Figure 2.
Figure 2 The Short-Rate Tree
25.53
21.79
19.42 19.48
14.32 16.06
10 13.77 14.86
9.79 11.83
9.76 11.34
8.72
8.65