Using the Black-Derman-Toy interest rate model for portfolio optimization

Alex Weissensteiner

European Journal of Operational Research, 2010, vol. 202, issue 1, 175-181

Abstract: No-arbitrage interest rate models are designed to be consistent with the current term structure of interest rates. The diffusion of the interest rates is often approximated with a tree, in which the scenario-dependent fair price of any security is calculated as the present value of the risk-neutral expectation by backward induction. To use this tree in a portfolio optimization context it is necessary to account for the so-called "market price of risk". In this paper we present a method to change the conditional probabilities in the Black-Derman-Toy model to the physical (or real) measure, including the market price of risk, and explore the economic implications for expected spot rates and for expected bond returns.

Keywords: Finance; Stochastic; programming; Asset/liability; management; Change; of; measure; Portfolio; optimization (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:202:y:2010:i:1:p:175-181

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