Interest rate trees: extensions and applications

John Hull and Alan White

Quantitative Finance, 2018, vol. 18, issue 7, 1199-1209

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.

Date: 2018
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DOI: 10.1080/14697688.2017.1406131

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