@MISC{_binomialpricing, author = {}, title = {BINOMIAL PRICING OF INTEREST RATE DERIVATIVES}, year = {} }

Share

OpenURL

Abstract

This teaching note shows how a binomial term structure can be used to price derivatives based on interest rates. It does not get into the issue of how to fit a binomial model of the term structure. It assumes that an arbitrage-free binomial model has already been derived. It further assumes that the derivatives are based only on the one-period interest rate. Accordingly, let us use a four-period binomial model that is represented by the following tree containing the evolution of one-period rates. We shall use 0.5 as the up-state probability and 0.5 as the down-state probability. These are, of course, the risk neutral/equivalent martingale probabilities, not the actual probabilities. The tree is fit using the Ho-Lee model.