A Multi-Factor Binomial Interest Rate

Model with State Time Dependent

Volatilities
By
Thomas S. Y. Ho
And
Sang Bin Lee
May 2005

Applications of Multi-factor
Interest Rate Models

Valuation of interest rate options,

mortgage-backed, corporate/municipal
bonds,
Balance sheet items: deposit accounts,
annuities, pensions,
Corporate management: risk management,
VaR, asset/liability management
Regulations: marking to market, SarbaneOxley
Financial modeling of a firm: corporate
finance

Interest Rate Models /Challenges

Interest rate models: Cox, Ingersoll and Ross,

Vasicek
Binomial models: Ho-Lee, Black, Derman and Toy
Extensions of normal model: Hull-White
Generalized continuous time models: Heath,
Jarrow, Morton approach
Market models: Brace, Gatarek, and
Musiela/Jamshidian
Discrete time models: Das-Sundaram, Grant-Vora
What is a practical model?

Requirements of Interest
Rate Models

Arbitrage-free conditions satisfied

Can be calibrated to a broad range of
securities, not just
swaptions/caps/floors
Multi-factor to capture the changing
shape of the yield curve
Consistent with historical observations:
mean reversion, no unreasonably high
interest rate, no negative interest rates

Outline of the Presentation

Motivations of the model

Model assumptions: mathematical
construct
Key ideas of the theory: Extending from
Ho-Lee model (1986, 2004)
Model theoretical and empirical results
Practical applications of the model
Conclusion: challenges to mathematical
finance

Model Assumptions

Binomial model: Cox Ross Rubinstein

Arbitrage-free condition:

Consistent with the spot curve

Expected risk free return at each node for all
bonds

Recombining condition
General solution: risk neutral
probabilities and time/state dependent
solutions

Continuous Time
Specification

dr = f(r,t)dt + (r, t) dz
(r, t) = (t) r for r < R
= (t) R for r > R

Ho-Lee 1-factor Constant

Volatilities Model

n 1
n 2

(1

)(1

) L(1 )

P(T n)
n
Pi (T) 2
P(n)
(1)
T n 1 L(1 )T

iT

P(T) discount
fn
Forward price
Convexity
term
Uncertainty
term

The Ho-Lee n-Factor Time

Dependent Model
forward/spot volatilities

n
2 P (T n)
Pi,j (T) 2

P ( n)

i
1
T n 1, n

1 d n11,k

k 1 1 dT n 1, k
n

2
T n 1, n

1 d n21, k

1 d
k 1

2
T n 1, k

The Generalized Ho-Lee

Model
k 1
n
i 1
(1

(
n

k
))
P
(
n

1)
n 1
0
Pi n

j
k 1
P (n) k 1 (1 0 (n k 1)) j 0
n 1

n
n
n 1
i 1 (T 1)
i (T ) i i (T 1)

n 1
1

(
T

1)
i

exp(2 (n) min( R , R)t )

n
i

n
i

3/ 2

Calibration Procedure

Forward looking approach: implied

market expectations, no historical data
used
Specify the two term structures of
volatilities by a set of parameters: a,b,
,e
Non-linear estimate the parameters such
that the sum of the mean squared %
errors in estimating the benchmark
securities is minimize

Market Observed Volatility

Surface(%): An Example
Option
Term

Swap tenor

Cap
volatility

1 yr

3 yr

5 yr

7 yr

10 yr

1 yr

37.2

29.3

25.4

23.7

22.2

42.5

2 yr

28.3

24.8

22.7

21.7

20.5

40.5

3 yr

25.0

22.9

21.3

20.5

19.4

34.6

4 yr

22.7

21.3

20.0

19.4

18.3

31.1

5 yr

21.5

20.2

18.9

18.3

17.2

28.7

7 yr

19.2

18.0

16.9

16.2

15.5

25.5

10 yr

16.8

15.5

14.6

14.1

13.6

22.6

Estimated Average Errors

in %
70 swaptions observations/date;11/03-5/04
monthly data
Generalized HoLee

Ho-Lee (2004)

One factor

2.80

2.58

Two factor

1.54

1.75

Principal Yield Curve Movements

98% parallel shift, 2% steepening

Rate Shift

Two yield curve movements implied by the Two Factor Ho-Lee Model
level

0.2

steepness

-0.2
2

8
10
12
14
16
18
20
Time-to-Maturity (years)
Two yield curve movements implied by historical level data (1998-2004)

Rate Shift

0.4

level

0.2
0
steepness

-0.2
2

8
10
12
14
Time-to-Maturity (years)

16

18

20

Davidson and MacKinnon C Test

Comparison of Alternative
Models

Yi (1 ) i i %
i
Yi i ( i i ) %
i

2-Factor Model vs 1-Factor

Model

H0 : the one factor model is better

than the two factor model
H1 : the two factor model is better than
the one factor model
t-test
coefficient std error t-value pvalue
2.22 0.17 13.21 0.00
Two factor model is accepted

1 factor model vs 2 factor

model

Lognormal vs Normal
Model

H0: The threshhold rate is 9%

H1: The threshold rate is 3%
t-test: on 5/31/2004
Coefficient std error t-value p-value
2.648
0.661
4.007
0.004
The results are mixed. Depends on the
date

Normal vs Lognormal
models

1Factor Model Lattice

intuitive results
One Month Interest Rate on the Lattice of the Generalized Ho-Lee Model

0.6
0.5
0.4
0.3
0.2
0.1
0
-0.1

20

40

60
10-year term

80

100

120

In Contrast: Lognormal Model with

Term Structure of Volatilities
1

1000 Randomly Simulated Paths from Lattice of the one Factor BDT Model

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

20

40

60
10 year term

80

100

120

Combining Two Risk Sources: Extended to

Stock/Rate Recombined Lattice

Advantages of the Model: a

Comparison

Arbitrage-free model: takes the market curve as

given relative valuation and use of key rate
durations
Accepts volatility surface, contrasts with market
model
Minimize model errors, contrasts with nonrecombining interest rate models
Accurate calibration for a broad range of securities
A comparison with the continuous time model:
specification of the instantaneous volatility

Applications of the Model

A consistent framework for pricing an interest rate

contingent claims portfolio

Portfolio strategies: static hedging

Ho-Lee Journal of Investment Management 2004

Modeling a business: corporate finance

Ho Journal of Investment Management 2004

Building structural models: credit risk

Ho-Lee Financial Modeling Oxford University Press 2004

Balance sheet management:

Ho-Lee Journal of Fixed-Income 2004

Ho-Lee working paper 2004

Use of efficient sampling methods in the path space of

the lattice:

Ho Journal of Derivatives LPS

Applications to Modeling a
Firm

Financial statements

Primitive Firm

Fair value accounting, comprehensive

income
Revenues determine the risk class

Correlations of revenues to the balance

sheet risks
Firm is a contingent claim on the market
prices and the primitive firm value

Applications of the
Corporate Model

A relative valuation of the firm

A method to relative value equity
and all debt claims
Risk transform from all business
risks to the net income
Enterprise risk management
An integration of financial
statements to financial modeling

Applications to Mathematical
Finance

Lattice model offers a co-ordinate system for

efficient sampling and new approaches to
modeling
Information on each node is a fiber bundle
Lattice is a vector space, Bond is a vector
Arrow-Debreu securities defined at each node
Embedding a Euclidean metric in the manifold
to measure risks
Can we approximate any derivatives by a set
of benchmark securities? Replicate securities?

Conclusions

N-factor models are important to some of

the applications of interest rate models in
recent years
The model offers computational
efficiency
The model provides better fit in the
calibrating to the volatility surface when
compared with some standard models
Avenues for future research