Interest Rate Trees: Extensions and Applications
32 Pages Posted: 9 Mar 2017 Last revised: 18 Sep 2017
Date Written: September 13, 2017
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 modeling flexibility when interest rates are negative.
Keywords: Term Structure, No-Arbitrage Model, Tree, Alternative Drift Functions, Real World, Risk-Neutral World, Negative Interest Rates
JEL Classification: G12, G13, G20
Suggested Citation: Suggested Citation