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The Binomial Model

The document describes the binomial model for valuing bonds. It assumes interest rates can take one of two possible values in each time period, with equal probabilities. The relationship between the two possible rates is determined by volatility. The model builds a tree showing how rates may evolve over time. Bond valuation works backwards through the tree using risk-neutral probabilities to calculate present values at each node. An example applies the model to value a 4-year bond.

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70 views

The Binomial Model

The document describes the binomial model for valuing bonds. It assumes interest rates can take one of two possible values in each time period, with equal probabilities. The relationship between the two possible rates is determined by volatility. The model builds a tree showing how rates may evolve over time. Bond valuation works backwards through the tree using risk-neutral probabilities to calculate present values at each node. An example applies the model to value a 4-year bond.

Uploaded by

glbit
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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The Binomial Model

THE BINOMIAL MODEL

• Valuation model that assumes interest rate will take one of


the two possible rates in the next period.
• For a given interest rate volatility, the probabilities of these
two events are the same.

Binomial Interest Rate Tree

r3, HHH
• N
HHH
r2, HH
• N
HH
r1, H r3, HHL
• N • N
H HHL
r0 r2, HL
• • N
N HL
r1, L r3, HLL
• N • N
L HLL
r2, LL
• N
LL
r3, LLL
• N
LLL

Now Year 1 Year 2 Year 3

ri = 1-year forward rates (i = 0,1,2,…..n)


r1, L = the lower 1-year rate one year from now
r1, H = the higher 1-year rate one year from now

1
The Binomial Model

Assuming that the interest rates evolve over time based on the
lognormal random walk with a known volatility ( σ ), the
relationship between r1, L and r1, H can be linked as follows:

r1, H = r1, L (e 2σ)

where ‘e’ is the base of natural logarithm, 2.71828

For example:

Suppose that r1, L = 4.4448% and σ = 10% per year, then:

r1, H = 4.4448 %( e 2×0.10 ) = 5.4289%

In the second year,


r2, HL = r2, LL (e 2σ)
r2, HH = r2, LL (e 4σ)

In the third year,


r3, HLL = r3, LLL (e 2σ)
r3, HHL = r3, LLL (e 4σ)
r3, HHH = r3, LLL (e 6 σ)

Determining Bond Value Using Binomial Model

Backward induction – the process starting from the last year in the
tree and working backwards.

2
The Binomial Model

• VH + C Cash Flow in
Higher-rate state
1-year rate at V
node where r*
•
bond’s value is
sought • VL + C Cash Flow in
Lower-rate state

VH = bond’s value for the higher 1-year rate


VL = bond’s value for the lower 1-year rate
C = coupon payment

The cash flow at a node is either:

VH + C or,
VL +C

The Present value of these two cash flows using the 1-year rate at
the node, r* , is:

VH + C
(1 + r* ) = present value for the higher rate

VL + C
(1 + r* ) = present value for the lower rate

Since the probabilities of these two events are the same, the value
of the bond at the node is found as follows:

1  VH + C VL + C 
Value at a node = +
2  (1 + r* ) (1 + r* ) 

3
The Binomial Model

Example:

Binomial Interest Rate Tree for Valuing Bond with Maturity up to


Four Year (10% Volatility Assumed)

9.1987 %
• N
HHH

7.0053 %
• N HH
5.4289 % 9.1987 %
• NH
• N
HHL

3.5% 5.7354 %
• • N HL
N
4.4448 % 9.1987 %
• NL
• N HLL
4.6958 %
• N LL
9.1987 %
• N LLL

Now Year 1 Year 2 Year 3

Valuing an Option-Free Bond with 4 Years to Maturity and


Coupon Rate of 6.5% (10% Assumed Volatility)

100.00
97.529 6.5
6.5
97.92 9.198% 100.00
6.5
100.23 99.041 6.5
7.005%
6.5 6.5
5.428% 4 7.531%
The Binomial Model

100.41
104.64 100.00
6.5
103.38 100.31 6.5
5.735%
3.5% 6.5 6.5
4.444% 102.53 6.166%
6.5 100.00
4.695% 101.38 6.5
6.5
5.048% 100.00
6.5

Now Year 1 Year 2 Year 3 Year 4

1 100 + 6.5 100 + 6.5 


At node N HHH = 2(1.09198
+
(1.09198 

= 97.529

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