Interest rate trees: extensions and applications |
| |
Authors: | John Hull Alan White |
| |
Affiliation: | Joseph L. Rotman School of Management, University of Toronto, Toronto, Canada |
| |
Abstract: | This paper provides extensions to existing procedures for representing one-factor no-arbitrage models of the short rate in the form of a tree. It allows a wide range of drift functions for the short rate to be used in conjunction with a wide range of volatility assumptions. It shows that, if the market price of risk is a function only of the short rate and time, a single tree with two sets of probabilities on branches can be used to represent rate moves in both the real-world and risk-neutral world. Examples are given to illustrate how the extensions can provide modelling flexibility when interest rates are negative. |
| |
Keywords: | Term structure No-arbitrage model Tree Alternative drift functions Real world Risk-neutral world Negative interest rates |
|
|