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1 Binomial-Lattice Models
In these lecture notes1 we introduce binomial-lattice models for modeling the “short-rate”, i.e. the one-period
spot interest rate. We will also use these models to introduce various interest rate derivatives that are
commonly traded in the financial markets. First we define what an arbitrage means.
Arbitrage
A type A arbitrage is an investment that produces immediate positive reward at t = 0 and has no future cost
at t = 1. An example of a type A arbitrage would be somebody walking up to you on the street, giving you a
positive amount of cash, and asking for nothing in return, either then or in the future.
A type B arbitrage is an investment that has a non-positive cost at t = 0 but has a positive probability of
yielding a positive payoff at t = 1 and zero probability of producing a negative payoff then. An example of a type
B arbitrage would be a stock that costs nothing, but that will possibly generate dividend income in the future.
In finance we always assume that arbitrage opportunities do not exist since if they did, market forces would
quickly act to dispel them.
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1 Many of our examples are drawn from Investment Science (1998) by David G. Luenberger.
t=0 t=1 t=2 t=3 t=4
Term Structure Lattice Models 2
We use risk-neutral pricing on this lattice to compute security prices. For example, if Si (j) is the value of a
non-dividend / coupon2 paying security at time i and state j, then we insist that
1
Si (j) = [qu Si+1 (j + 1) + qd Si+1 (j)] (1)
1 + ri,j
where qu and qd are the probabilities of up- and down-moves, respectively. If the security pays a coupon then it
should be included in the right-hand side of (1). Such a model is arbitrage-free by construction.
Exercise 1 Can you see why (1) implies that the lattice is arbitrage-free?
2 Since these notes focus on fixed-income securities, we will henceforth refer to any intermediate cash-flow as a coupon.
Term Structure Lattice Models 3
Note that given the price of the 4-period zero-coupon bond, we can now find the 4-period spot rate, s4 . It
satisfies 77.22 = 1/(1 + s4 )4 if we quote spot rates on a per-period basis. In this manner we can construct the
entire term-structure by evaluating zero-coupon bond prices for all maturities.
0.00
4.92 0.00 American Put Option
8.73 0.65 0.00 Strike = $88
10.78 3.57 0.00 0.00
3 Of course the forward equations are themselves derived using risk-neutral pricing so they really add nothing new to the
theory.
Term Structure Lattice Models 4
F0 = EQ
0 [Sn ] . (2)
Remark 1 Note that the above argument holds regardless of whether or not the underlying security pays
dividends or coupons as long as the settlement price, Sn , is ex-dividend. In particular, we can use (2) to price
futures on zero-coupon and coupon bearing bonds.
Remark 2 If Bn and Sn are Q-independent, then G0 = F0 . In particular, if interest rates are deterministic, we
have G0 = F0 .
Remark 3 If the underlying security does not pay dividends or coupons (storage costs may be viewed as
negative dividends), then we obtain G0 = S0 /EQ n n
0 [1/Bn ] = S0 /Z0 where Z0 is the date t = 0 price of the
zero-coupon bond that matures at time n.
assume a complete market so that we can uniquely price any security and more generally, the futures price process. But don’t
worry if you are not familiar with the concept.
5 We assume without loss of generality that B is the value of the cash account at t = n when $1 was deposited there at
n
t = 0.
6 A martingale is a process where the expected change in the value of the process at any time is always zero.
Term Structure Lattice Models 5
110.00
102.98 110.00
| 91.66 107.19 110.00
85.08 | 98.44 110.46 110.00
81.53 93.27 |103.83 112.96 110.00
79.99 90.45 99.85 |108.00 114.84 110.00
79.83 89.24 97.67 104.99 |111.16 116.24 110.00
Caplet Strike = 2%
0.138
0.103 0.099
0.080 0.076 0.068
0.064 0.059 0.053 0.045
0.052 0.047 0.041 0.035 0.028
0.042 0.038 0.032 0.026 0.021 0.015
Remark 4 In practice caplets are usually based on LIBOR (London Inter-Bank Offered Rates).
Caps: A cap is a string of caplets, one for each time period in a fixed interval of time and with each caplet
having the same strike price, c.
Floorlets: A floorlet is similar to a caplet, except it has payoff (c − rτ −1 )+ and is usually settled in arrears at
time τ .
Floors: A floor is a string of floorlets, one for each time period in a fixed interval of time and with each floorlet
having the same strike price, c.
It is easily seen that the elementary security prices satisfy the forward equations:
Pe (k, s − 1) Pe (k, s)
Pe (k + 1, s) = + , 0<s<k+1
2(1 + rk,s−1 ) 2(1 + rk,s )
1 Pe (k, 0)
Pe (k + 1, 0) =
2 (1 + rk,0 )
1 Pe (k, k)
Pe (k + 1, k + 1) =
2 (1 + rk,k )
Since we know Pe (0, 0) = 1 we can use the above equations to evaluate all the state prices by working forward
from node N (0, 0). Working with state prices has a number of advantages:
1. Once you compute the state prices they can be stored and used repeatedly for pricing derivative securities
without needing to use backwards iteration each time.
2. In particular, the term structure can be computed using O(T 2 ) operations by first computing the state
prices. In contrast, computing the term structure by first computing all zero-coupon bond prices using
backwards iteration takes O(T 3 ) operations. While this makes little difference given today’s computing
power, writing code to price derivatives in lattice models is often made easier when we price with the state
prices.
Term Structure Lattice Models 7
3. They can be useful for calibrating lattice models to observed market data.
It should be noted that when pricing securities with an early exercise feature, state prices are of little help and it
is still necessary to use backwards iteration.
Example 7 (a) Consider the short rate lattice of Figure 4.1 where interest rates are expressed as percentages.
You may assume the risk-neutral probabilities are given by q = 1 − q = 1/2 at each node.
10.14
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Use the forward equation to compute the elementary prices at times t = 0, t = 1 and t = 2.
(b) Consider the different short rate lattice of Figure 4.2 where again you may assume q = 1 − q = 1/2. The
short rates and elementary prices are given at each node. Using only the elementary prices, find the price of a
zero-coupon bond with face value $100 that matures at t = 3.
(c) Compute the price of a European call option on the zero-coupon bond of part (b) with strike = $93 and
expiration date t = 2.
(d) Again referring to Figure 4.2, suppose you have an obligation whose value today is $100 and whose value at
node (1, 1) (i.e. when r = 7.2%) is $95. Explain how you would immunize this obligation using date 1
elementary securities?
(e) Consider a forward-start swap that begins at t = 1 and ends at t = 3. The notional principal is $1 million,
the fixed rate in the swap is 5%, and payments at t = i (i=2,3) are based on the fixed rate minus the floating
rate that prevailed at t = i − 1. Compute the value of this forward swap.
Term Structure Lattice Models 8
10.37, .1013
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8.64, .22 7.78, .3096
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7.2, .4717©© 6.48, .4438©© 5.83, .3151
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6, 1 © 5.4, .4717 © 4.86, .2238 © 4.37, .1067
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Solution
(a) Pe (0, 0) = 1, Pe (1, 0) = .4717, Pe (1, 1) = .4717, Pe (2, 0) = 0.2238, Pe (2, 1) = 0.4426, Pe (2, 2) = 0.2188.
(b) (.1013 + .3096 + .3151 + .1067) × 100 = 83.27.
(c) The value of the zero coupon bond at nodes (2, 0), (2, 1) and (2, 2) are 95.3652, 93.9144 and 92.0471
respectively. This means the payoffs of the option are 2.3652, .9144 and 0 respectively. Now use the time 2
elementary prices to find that the option price equals 2.3652 × .2238 + .9144 × .4438 = .9351.
(d) First find the value, x, of the obligation at node (1, 0). It must be that x satisfies
1 95 1 x
100 = +
2 1.06 2 1.06
which implies x = 117. So to hedge the obligation, buy 95 node (1, 1) state securities and 117 node (1, 0) state
securities. The cost of this is 117 × .4717 + 95 × .4717 = 100, of course!
(e) The value of the swap today is (why?)
ri,j = ai + bi j.
Note that ai is a drift parameter while bi is a volatility parameter. In particular, the standard deviation of the
short-rate at node N (i, j) is equal to bi /2.
Term Structure Lattice Models 9
Note that Equation (4) can now be used to solve iteratively for the ai ’s as follows:
• Set i = 1 in (4) and note that Pe (0, 0) = 1 to see that a0 = s1 .
• Now use the forward equations to find Pe (1, 0) and Pe (1, 1).
• Now set i = 2 in (4) and solve for a1 .
• Continue to iterate forward until all ai ’s have been found.
By construction, this algorithm will match the observed term structure to the term structure in the lattice.
to note that it is much easier to record time t cash flows (for t = 3, . . . , 10) at their predecessor nodes at time
t − 1, discounting them appropriately. This is why in the swaption lattice above, there are no payments recorded
at t = 10 despite the fact that payments do actually take place then.
Exercise 3 Why is it more convenient to record those cashflows at their predecessor nodes?
The option is then exercised if and only if S2 > 0. In particular, the value of the swaption at maturity (t = 2) is
max(0, S2 ). This is then discounted backwards to t = 0 to find a swaption value today of .0013.
15.90
13.45 15.82
Short-Rate Lattice 13.01 13.38 15.74
13.24 12.94 13.32 15.66
12.02 13.18 12.88 13.25 15.58
12.38 11.96 13.11 12.81 13.18 15.50
9.58 12.31 11.90 13.05 12.75 13.12 15.43
9.11 9.53 12.25 11.84 12.98 12.69 13.05 15.35
7.96 9.07 9.48 12.19 11.78 12.92 12.62 12.99 15.27
7.30 7.92 9.02 9.44 12.13 11.72 12.85 12.56 12.92 15.20
Year 0 1 2 3 4 5 6 7 8 9
Spot 7.3 7.62 8.1 8.45 9.2 9.64 10.12 10.45 10.75 11.22
a 7.30 7.92 9.02 9.44 12.13 11.72 12.85 12.56 12.92 15.20
0.0366
Pricing a 2-8 Payer Swaption 0.0479 0.0360
0.0539 0.0467 0.0353
0.0610 0.0523 0.0456 0.0347
0.0568 0.0590 0.0508 0.0444 0.0340
0.0560 0.0546 0.0571 0.0492 0.0433 0.0334
|0.0311 0.0535 0.0524 0.0552 0.0477 0.0422 0.0327
0.0040 |0.0284 0.0511 0.0502 0.0533 0.0461 0.0411 0.0321
0.0024 0.0011 |0.0257 0.0486 0.0480 0.0514 0.0446 0.0399 0.0314
0.0013 0.0005 0.0000 |0.0230 0.0461 0.0458 0.0495 0.0431 0.0388 0.0308
Year 0 1 2 3 4 5 6 7 8 9
A related derivative instrument that is commonly traded is a Bermudan swaption (payer or receiver). This is the
same as a swaption except now the option can be exercised at any of a predetermined set of times,
T = (t1 , . . . , tm ).
Term Structure Lattice Models 11
4 Multi-Factor Models
The binomial models that we have studied are all examples of so-called one-factor models. A one-factor model is
a model where there is just one source of uncertainty. In the binomial model of the short-rate, the uncertainty in
each period revolves around whether the short-rate moves up or down in the next period. It is well known from
empirical observations, however, that the term structure of interest rates is not well described by a one-factor
model. In particular, two-factor or three-factor models are required to provide an adequate explanation of
term-structure movements. As a result, the binomial models of these notes and their continuous-time
counterparts are not used in practice. Nonetheless, they provide an excellent introduction to the pricing of
fixed-income securities and allow us to introduce the most commonly traded fixed-income derivatives.
References
Luenberger, D.G. 1998. Investment Science, Oxford University Press, New York.