Interest Rate Trees: Extensions and Applications

32 Pages Posted: 9 Mar 2017 Last revised: 18 Sep 2017

See all articles by John C. Hull

John C. Hull

University of Toronto - Rotman School of Management

Alan White

University of Toronto - Rotman School of Management

Date Written: September 13, 2017

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 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

Hull, John C. and White, Alan, Interest Rate Trees: Extensions and Applications (September 13, 2017). Rotman School of Management Working Paper No. 2928975, Available at SSRN: https://ssrn.com/abstract=2928975 or http://dx.doi.org/10.2139/ssrn.2928975

John C. Hull (Contact Author)

University of Toronto - Rotman School of Management ( email )

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Alan White

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-3689 (Phone)
416-971-3048 (Fax)

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