FM405: Chapter II

Foundations of interest rate modeling

Péter Kondor

London School of Economics, and FMG

1 P. Kondor Chapter II ⟲
Outline

1 Trees

2 A One-Step Interest Rate Binomial Tree

3 Multi-Step Interest Rate Binomial Trees

2 P. Kondor Chapter II ⟲
II.1 Trees
The classical ideas of option valuation through binomial trees
can be applied to pricing fixed income instruments, although
this requires revising quite a few methodological details.

General idea: create a probabilistic representation of how the

price develops over time using a tree-information structure

4 P. Kondor Chapter II ⟲
 n be two mutually exclusive states of the world:
state “up”,
Example: occurring
at the with probability
time of evaluation, we observe p, the and
state. the
Nextstate
period,“down”
there can be two mutually exclusive states of the world:
probability 1 The
− p. state “up”, occurring with probability p, and the state
two periods, “down”,
there can be three
occurring mutually
with probability exclusive states of the
1 − p.
After two
ollowing diagram. Weperiods,
label there
the can
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thismutually
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of the world, as in the following diagram. We label the tree in
asize that thethis“up & down”
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to emphasize thatnodes
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& down” and the “down & up” nodes are the same.
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5 P. Kondor Chapter II ⟲
 The previous diagram can be used to price options written on
stocks. The stock price unfolds through the branches of the
tree. Then, we figure out the no-arbitrage movements of the
option price along the tree.
Suppose we wish to price an option written on a 3-Year zero.
Can we apply the same methodology to price other options?
No! We can not exogenously “track” the movements of the prices
of the zero, as in the stock price case: after one year, the
3-Year zero becomes a 2-Year zero, i.e. a quite different asset.
A Trick: The trick, here, is to model the movements of the yield curve.
In particular,
i) we model the dynamics of the short-term rate, defined as the
interest rate on a loan with maturity equal to the time
intervals in the tree. The resulting model, which we call model
of the short-term rate, has implications in terms of the
movements of the entire term-structure.

6 P. Kondor Chapter II ⟲
II.2 A One-Step Interest Rate Binomial Tree
An interest rate tree starts with the specification of the
dynamics of the short-term interest rate in conjunction with
the data we have from the yield curve:

Maturity Price Yield

0.5 99.1338 1.74%
1 97.8925 2.13%
1.5 96.1462 2.62%
Table 1: Treasury STRIPS on Jan 8, 2002 - Source: The WSJ

These dynamics reflect our predictions of future interest rates.

We take the short-term interest rate as exogenous, in the
sense that it is driven by monetary policy choices, and market
participants cannot affect it.
In principle, this characteristic is really appropriate for the
overnight (Federal funds) rate, but for now we keep matters
simple, and we take the 6-month rate as the exogenous rate.
9 P. Kondor Chapter II ⟲
 Figure 1: Term structure of Interest Rates on January 8, 2002. Source:
U.S. Department of the Treasury.

10 P. Kondor Chapter II ⟲
 A One-Period Binomial Interest Rate Tree
How to come up with an interest rate tree?
One option is to predict the expected interest rate and specify
a range of uncertainty around it, e.g., 2.17% ± 1.22%.

period i =0 i =1

time (in years) t=0 t = 0.5

r1,u = 3.39% with prob p = 1/2

5
r0 = 1.74%
)
r1,d = 0.95% with prob 1 − p = 1/2
notation: ri,j short interest rate in period i (as opposed to
time t) and state (i.e. node) j
A tree of short rates implicitly imposes restrictions across all
bonds. If r0 goes up, it will affect both the 1-year bond and
the 1.5 year bond. The FED and the BoE use this fact.
11 P. Kondor Chapter II ⟲
 The model could use any rate, at any compounding frequency;
We chose to model the binomial tree using continuously
compounded rate.
However, remember that there is always a one-to-one relation
between continuously compounded rates and any other rate, ie.
r

rn = n × e n − 1 ,

where n is the number of compounding periods per year, r is the

continuously compounded rate, and rn is the n-times compounded
rate.

12 P. Kondor Chapter II ⟲
 The Binomial Tree for a Two-Period Zero Coupon Bond
Let Pi,j (k) be the zero coupon bond price in period i, in node
j, and with maturity in period k;

i =0 i =1 i =2
t=0 t = 0.5 t=1

P (2) = 100
3 2,uu
4?
+
P0 (2) = 97.8925 P2,ud (2) = P2,du (2) = 100
3
*?
+
P2,dd (2) = 100

13 P. Kondor Chapter II ⟲
 From the previous tree we can obtain the process for a zero
coupon maturing at k = 2 (Pi,j (k) zero price with maturity in
period k in period i and state j):
i =0 i =1 i =2
t=0 t = 0.5 t=1

2 P2,uu (2) = 100

P1,u (2) = e −r1u ×0.5 × 100
2 = 98.3193 -

P0 (2) = 97.8925 P2,ud (2) = P2,du (2) = 100

, 2
P1,d (2) = e −r1d ×0.5 × 100
= 99.5261 -

P2,dd (2) = 100

Table (*) - The One-Year Zero Coupon Bond Binomial Tree.

14 P. Kondor Chapter II ⟲
 No Arbitrage On a Binomial Tree
We now exploit the binomial tree for the one-year zero coupon
bond in Table (*) to obtain the fair, no-arbitrage price of
additional securities whose final payoff depends on the interest
rate.
Consider the following option: (Payoff at i = 1) = 100 × max(rK − r1 , 0)
where rK is the strike price (assume rK = 2%).
So for the tree we have that:
(Payoff at i = 1 if r1,u ) = 0.00
(Payoff at i = 1 if r1,d ) = 1.05

Consider the following portfolio

Buy 0.8700 of bonds with k = 2 → −0.8700 × $97.8925 = −$85.1703
Short 0.8554 of bonds with k = 1 → +0.8554 × $99.1338 = $84.8007

What is the value of this portfolio at i = 1?

Value of Portfolio if r1,u → 0.8700 × P1,u (2) − 0.8554 × $100 = $0.00
Value of Portfolio if r1,d → 0.8700 × P1,d (2) − 0.8554 × $100 = $1.05
15 P. Kondor Chapter II ⟲
 Note that the value of the portfolio is identical to the value of
the option. In other words the portfolio replicates the payoff
of the option.
If they both have the same payoff, then it follows that,
assuming there are no arbitrage opportunities, they should
have the same price (which means that the option’s price
85.1703 − 84.8007 = $0.3697).
A replicating portfolio of a security with payoffs V1,u and V1,d
in the two nodes u and d at time i = 1 is a portfolio of bonds
that exactly replicates the values of the security at time i = 1.
That is, if Πi,j denotes the value of the portfolio at time i in
node j, we have Π1,u = V1,u and Π1,d = V1,d . The value of
the option at i = 0 equals the value of the portfolio Π0 = V0 .

16 P. Kondor Chapter II ⟲
The Replicating Portfolio Via No Arbitrage
Consider a portfolio Π with N1 units of the bond with
maturity i = 1 and N2 units of the bond with maturity i = 2,
at time i = 0 it’s value is:
Π0 = N1 × P0 (1) + N2 × P0 (2)
At time i = 1, the portfolio value will be:
Π1,u = N1 × 100 + N2 × P1,u (2)
Π1,d = N1 × 100 + N2 × P1,d (2)

Assume that we are trying to replicate a security that takes

values V1,u and V1,d , so we have that:
Π1,u = N1 × 100 + N2 × P1,u (2) = V1,u
Π1,d = N1 × 100 + N2 × P1,d (2) = V1,d
Subtracting one from the other, we get:
N2 × (P1,u (2) − P1,d (2)) = V1,u − V1,d
17 P. Kondor Chapter II ⟲
 Solving for N2
V1,u − V1,d
N2 = (1)
P1,u (2) − P1,d (2)
Given N2 , the solution for N1 is:

N1 = [V1,u − N2 × P1,u (2)]/100 (2)

or, using the equation above for Π1,d

N1 = [V1,d − N2 × P1,d (2)]/100 (3)

These give N1 and N2 in

V0 = Π0 = N1 × P0 (1) + N2 × P0 (2)

Question: Where is p?

18 P. Kondor Chapter II ⟲
 Risk Premia in Interest Rate Securities
Computing the present value of P1 (2) we get:
e −r0 ×∆ E [P1 (2)] = 0.9913×(p×98.3193+(1−p)×99.5261) = 98.065

This is higher than the observed price (from the yield curve):

P0 (2) = 97.8925 < e −r0 ×∆ E [P1 (2)] = 98.065

The price is lower because of a risk premium embedded in the

price of longer term bonds.
An investment in Treasury securities is risky because an
investor may suffer capital losses if the bond is sold before
maturity.
The Dollar Risk Premium from investing in the long term
bond with maturity i = 2 is defined as:

e −r0 ×∆ E [P1 (2)] − P0 (2)

19 P. Kondor Chapter II ⟲
 The Market Price of Interest Rate Risk
It turns out that in the absence of arbitrage, there is a
constant λ0 , such that the following relation holds true:

e −r0 ×∆ E [P1 (2)] − P0 (2) e −r0 ×∆ E [V1 ] − V0

λ0 ≡ = (4)
P1,u (2) − P1,d (2) V1,u − V1,d

The result comes from the logic of pricing by replication. The

proof is spelled out in the Appendix.

20 P. Kondor Chapter II ⟲
 Note the following:
The left hand side (LHS) only involves zero coupon prices and
the right hand side (RHS) only involves derivative security
prices.
The expressions on the LHS for the two period bond is identical
to the expression on the RHS for the derivative security.
The numerators of both expressions are simply the (dollar) risk
premium investors require from holding bonds (LHS) or the
derivative security (RHS).
The denominators represent the (dollar) risk of an investment
in bonds (LHS) or in the derivative security (RHS), as it is
given by the fluctuations of the security across the two possible
states.
So we have that, all interest rate securities on a binomial tree have the
same ratio between risk premium and risk:
Risk Premium e −r0 ∆ E [V1 ] − V0
= ≡ λ0
Risk V1,u − V1,d
where λ0 is common across all interest rate securities and is called the
market price of (interest rate) risk.
λ0 , being the risk premium per units of volatility, is simply a Sharpe ratio.
21 P. Kondor Chapter II ⟲
 An Interest Rate Security Price Formula
If we know λ0 at time i = 0, we can compute the price of any
security as:
V0 = e −r0 ×∆ E [V1 ] − λ0 (V1,u − V1,d ) (5)

How can we compute λ0 ? Using information on the bond with

maturity i = 2:
e −r0 ×∆ E [P1 (2)] − P0 (2)
λ0 =
P1,u (2) − P1,d (2)
Example: From Table (*) we obtain
98.0658 − 97.8925
λ0 = = −0.1436.
98.3193 − 99.5261

Check that pricing the interest rate option above gives the
same result
Why is this negative? What if we use the wrong p?
22 P. Kondor Chapter II ⟲
 Figure 2: Pricing the short-rate call option with strike price of 2% with
different p values.

23 P. Kondor Chapter II ⟲
 Risk Neutral Pricing
Since when p changes λ0 varies, in theory we could find a
value of p (which we can call q) that makes λ0 = 0. Since λ0
is common to all securities so should q.
When this occurs, from known bond prices, we get:
P0 (2) = e −r0 ×∆ E q [P1 (2)]
= e −r0 ×∆ (qP1,u (2) + (1 − q)P1,d (2)) (6)
Which leads to:
e r0 ×∆ P0 (2) − P1,d (2)
q=
P1,u (2) − P1,d (2)

The risk neutral probability q is the particular value of the

probability p such that every interest rate security is given by
the present value of expected payoff, where the present value
is computed using the risk free rate.
for any interest rate derivative priced on this tree we have
V0 = e −r0 ×∆ E q (V1 ) (7)
23 P. Kondor Chapter II ⟲
 Example: From Table (*) we obtain

e 0.0174×0.5 × 97.8925 − 99.5261

q= = 0.6448.
98.3193 − 99.5261

Check that in the example above

$0.3697 = e −r0 ×∆ E q (V1 ) = e −r0 ×∆ (qV1,u + (1 − q)V1,d )

indeed holds.

24 P. Kondor Chapter II ⟲
 A few considerations
We “expect” that λ0 < 0 because bond prices are decreasing
in the short-term rate here.
It is possible to show that1

q ≡ p − e r0 ×∆ λ0 > p .

Hence,
The risk-neutral probability of an upward movement of the
short-term rate, q, is higher than the true probability, p.
An investor who goes long a bond, is concerned by an increase
of the short-term rate in the future and, hence, “corrects” the
true probability p by assigning a higher risk-adjusted
probability to the “upward” state.
1
It comes from the equivalence of method 1 and 2:

e −r0 ×∆ (qV1,u + (1 − q)V1,d ) ≡ e −r0 ×∆ (pV1,u + (1 − p)V1,d ) − λ0 (V1,u − V1,d )

Also, if λ ≡ e r0 ×∆ λ0 , to be able to interpret q as a probability, we must have

that q ≡ p − λ > 0 ⇔ −λ > −p and q ≡ p − λ < 1 ⇔ −λ < 1 − p. That is,
−λ ∈ (−p, 1 − p).
25 P. Kondor Chapter II ⟲
 Risk Neutral Pricing and Dynamic Replication
It is important to realize that there is no underlying
assumption that market participants are risk neutral.
They are not, as in fact under the true probability, market
participants would require a risk premium to hold long-term
bonds. Underlying its logic is the existence of the replicating
portfolio.
What is key to realize, however, is that the dynamic replication
strategy exists among any two interest rate securities.

26 P. Kondor Chapter II ⟲
 1 The Replicating Portfolio Via No Arbitrage
Compute N1 and N2 (from equations (1) and (2));
Compute the price of the interest rate security V0 as the value
of the replicating strategy.
2 Market price of Risk
Compute the market price of risk λ0 from the known bond
data;
Compute the price of the interest rate security from the pricing
formula shown above (see Eq.(5)).
3 Present Discounted Values of future Cash Flows (Risk Neutral
Pricing)
Compute the risk neutral probability q;
Compute the price of the interest rate security from the pricing
formula Eq.(7).

27 P. Kondor Chapter II ⟲
 Risk Neutral Expectation of Future Interest Rates
The expected future interest rate under the risk neutral
probability is given by

E q [r1 ] = 0.6448 × 3.39% + 0.3552 × 0.95% = 2.5234%

This number is higher than the true expected interest rate,

which is equal to E [r1 ] = 2.17%:
Risk neutral pricing includes the risk premium in the
probability of an up move (from p to q) and thus increases the
predicted future interest rate;
However, this does not mean that the market participants
expect the interest rate in six months to be 2.5234% instead of
2.17%.
The forward rate is given by:
P0 (1)
 
f (0, 1, 2) = 2 × log = 2.52%
P0 (2)

28 P. Kondor Chapter II ⟲
 This has two implications:
Forward rates are not equal to the market expectation of
future interest rates;
Thus if today we observe high forward rates we should think
about two possibilities: (1) Market participants expect higher
future interest rates; (2) They are strongly averse to risk, and
thus the price of long term bonds is low today.
The forward rate is not even equal to the risk neutral future
interest rate, although they are quite close:
Recall that risk neutral pricing is based on the notion of
dynamic replication, which involves trading in securities;
Interest rates are related to securities prices through a convex
relation;
Thus the divergence between rates is because there is a
convexity adjustment missing to make both interest rates the
same. (In fact e −f (0,1,2)×∆ = E q [e −r1 ×∆ ])

29 P. Kondor Chapter II ⟲
II.2 Multi-Step Interest Rate Binomial Trees
A Two-Step Binomial Tree
Consider extending the tree to one more period:

i =0 i =1 i =2
t=0 t = 0.5 t=1

3 r2,uu = 5%
r1,u = 3.39%
4
+
r0 = 1.74% r2,ud = r2,du = 2.56%
* 3
r1,d = 0.95%
+
r2,dd = 0.11%

31 P. Kondor Chapter II ⟲
 Probability of up movement is p = 1/2;
So we have that:

E [r1 ] = 0.5 × r1,u + 0.5 × r1,d = 2.17%

E [r2 ] = 0.25 × r1,uu + 0.5 × r1,ud + 0.25 × r1,dd = 2.56%

Additionally, we obtain from the yield curve the following data:

Maturity Price Yield

0.5 99.1338 1.74%
1 97.8925 2.13%
1.5 96.1462 2.62%
Table 2: Treasury STRIPS on Jan 8, 2002 - Source: The WSJ

32 P. Kondor Chapter II ⟲
 Risk Neutral Expectation of Future Interest Rates
Key results:
We can obtain the price of any interest rate security at time 0
by using the risk neutral approach, that is:

V0 = e −r0 ×∆ E q [V1 ]
= e −r0 ×∆ (qV1,u + (1 − q)V1,d )

We can replicate the payoff of any interest rate security by

using another interest rate security.

33 P. Kondor Chapter II ⟲
 Risk Neutral Pricing by Backward Induction
We can compute the price of the three period bond by
starting from the end of the tree, and applying the one-step
risk neutral pricing formula repeatedly.
The 3-period zero coupon bond Tree with constant
q = 0.6448.
See Figure 3. For example,

P1,u (3) =
= e −0.0339×0.5 (0.6448 × 97.5310 + (1 − 0.6448) × 98.7282) =
= 96.3098

34 P. Kondor Chapter II ⟲
 i=0 i=1 i=2 i=3

t=0 t = 0.5 t=1 t = 1.5

P3,uuu (3) = 100

3

P2,uu (3) = 97.5310

5

+
P1,u (3) = 96.3098 P3,uud (3) = P3,udu (3) = P3,duu (3) = 100
6 3
q

)
P0 (3) = 96.3137 P2,ud (3) = P2,du (3) = 98.7282
5

( +
P1,d (3) = 98.6904 P3,udd (3) = P3,dud (3) = P3,ddu (3) = 100
3

)
P2,dd (3) = 99.9450

+
P3,ddd (3) = 100

Figure 3: The 3-Period Zero Coupon Bond Tree with Constant

q = 0.6448.

35 P. Kondor Chapter II ⟲
 Straddle
Consider a security that pays at i = 2, the following amount
(with K = 98.7282)
V2 = max(P2 (3) − K , 0) + max(K − P2 (3), 0)
Because it pays when the price is far away from K , this
strategy tends to payoff in an environment with high bond
price volatility;
The risk neutral pricing methodology can provide the price of
this security immediately by using a backward methodology:
Namely, we start from the end of the tree (i = 2) and compute
the payoffs of the security, and then we move backward on the
tree;
The risk neutral probability q to use is the same as above,
namely, q = 0.6448, as this probability applies to all interest
rate securities;
The price is V0 = 0.6366.
For example,
V1,u (2) = e −0.0339×0.5 (0.6448 × 1.1972) = 0.759
36 P. Kondor Chapter II ⟲
 i =0 i =1 i =2
t=0 t = 0.5 t=1

V2,uu (2) = 1.1972

3
V1,u (2) = 0.7590
3
+
V0 (2) = 0.6366 V2,ud = V2,du = 0
3
+
V1,d (2) = 0.4301
+
V2,dd = 1.2169

37 P. Kondor Chapter II ⟲
 Matching The Term Structure
It was assumed that the risk neutral probability q was the
same along the tree;
There is a problem! In fact the price for the 3-year bond is
obtained from the model is different from the observed price:

P0 (3)data = $96.1462 ̸= P0 (3)tree = $96.3137

If we assume q moves over time (i.e. qi ), we can find q1 by

choosing a value for it such that P0 (3)data = P0 (3)tree .

38 P. Kondor Chapter II ⟲
 Calculating q1 in a two-step tree
we know that

P0 = e −r0 ∆ (q0 P1,U + (1 − q0 ) P1,D )

P1,U = e −r1,U ∆ (q1 P2,UU + (1 − q1 ) P2,UD )
P1,D = e −r1,D ∆ (q1 P2,DU + (1 − q1 ) P2,DD )

As we have seen before, the interest rate tree gives prices at

date 2, P2,· , and we can calculate q0 from the 2 period zero.
However, we cannot find P1,U and P1,D from the first
equation just by knowing q0 and P0 (3) as that would be two
unknowns with one equation.
However, it is still possible to come up with a closed form
expression with sufficient algebra.

39 P. Kondor Chapter II ⟲
 instead, we have to substitute in the latter two equations into
the first one giving
 
q0 e −r1,U ∆ (q1 P2,UU + (1 − q1 ) P2,UD ) +
P0 = e −r0 ∆
(1 − q0 ) e −r1,U ∆ (q1 P2,DU + (1 − q1 ) P2,DD )

This has only one unknown, q1 . That is,

−r1,D ∆ −r1,U ∆


e r0 ∆ P0 − (1−q0 )e P 2,DD +q0 e P 2,UD
−r1,U ∆ −r1,U ∆ −r ∆

−r1,D ∆ = q1
q0 e P2,UU + −q0 e +(1−q0 )e 1,D P2,DU −(1−q0 )e P2,DD

Substituting in all the numbers from our example, this would

give q1 = 0.787
in general, we do this numerically

40 P. Kondor Chapter II ⟲
 Figure 4: Finding q1 (denoted as p1∗ here)

41 P. Kondor Chapter II ⟲
 i=0 i=1 i=2 i=3

t=0 t = 0.5 t=1 t = 1.5

P3,uuu (3) = 100

3

P2,uu (3) = 97.5310

5
q1

+
P1,u (3) = 96.1426 P3,uud (3) = P3,udu (3) = P3,duu (3) = 100
6 3
q0

)
P0 (3) = 96.1462 P2,ud (3), P2,du (3) = 98.7282
5
q1

( +
P1,d (3) = 98.5184 P3,udd (3) = P3,dud (3) = P3,ddu (3) = 100
3

)
P2,dd (3) = 99.9450

+
P3,ddd (3) = 100

Figure 5: The 3-Period Zero Coupon Bond Tree that Matches the Bond
Data. Risk Neutral Probabilities are q0 = 0.6448 and q1 = 0.7869.
41 P. Kondor Chapter II ⟲
 now we can recalculate the value of our straddle which is
consistent with the term-structure.
Straddle with q1 = 0.7869
i =0 i =1 i =2
t=0 t = 0.5 t=1

V2,uu (2) = 1.1972

3
V1,u (2) = 0.9263
3
+
V0 (2) = 0.6830 V2,ud = V2,du = 0
+ 3
V1,d (2) = 0.2580
+
V2,dd = 1.2169

42 P. Kondor Chapter II ⟲
 Multi-Step Trees
We now extend the model to trees with longer maturity, or
with more frequent steps. To build multi-steps trees, we use
the following methodology:
Define the predicted future interest rate E [ri ] for many future
horizons i = 1, 2, ..., n;
Define some errors of the predictions (e.g. r1,u = 3.39% and
r1,d = 0.95% are errors around the expected rate
E [r1 ] = 2.17%);
Find the risk neutral probabilities that price bonds.

43 P. Kondor Chapter II ⟲
 Building a Binomial Tree from Expected Future Rates
Define the expected change in interest rate in the future as
E [ri+1 − ri ]
mi =
∆
We then introduce errors in our predictions as follows
√
r1,u = r0 + m0 × ∆ + σ × ∆
√
r1,d = r0 + m0 × ∆ − σ × ∆
for the fist period, where up and down movement occur with
probability 1/2
For the second period:
√
r2,uu = r1,u + m1 × ∆ + σ × ∆
√
r2,ud = r1,u + m1 × ∆ − σ × ∆
√
r2,du = r1,d + m1 × ∆ + σ × ∆
√
r2,dd = r1,d + m1 × ∆ − σ × ∆
and so on.
44 P. Kondor Chapter II ⟲
 The notation we are using now is not well suited for longer
trees, we pass to the following notation:
(
ri+1,j an “up” movement in interest rates
ri,j =
ri+1,j+1 a “down” movement in interest rates

where we let ri,j be the continuously compounded interest rate in

node j between steps i and i + 1.
so let us start with predicting short rates, e.g., by running a
regression on rt+1 onto rt using data between Dec 1961 and
Dec 2001 and using the resulting coefficients for
out-of-sample forecast.

rt+1 =α + βrt + ϵt
rt+1 =0.006 + 0.9rt + ϵt

45 P. Kondor Chapter II ⟲
 Semester i Month/Year Model Prediction Ex post realization
1 Jul 2002 2.17% 1.71%
2 Jan 2003 2.56% 1.20%
3 Jul 2003 2.91% 0.95%
4 Jan 2004 3.22% 0.97%
5 Jul 2004 3.51% 1.67%
6 Jan 2005 3.77% 2.62%
7 Jul 2005 4.00% 3.45%
8 Jan 2006 4.22% 4.35%
9 Jul 2006 4.41% 5.12%
10 Jan 2007 4.58% 5.01%
Table 3: Interest Rate Prediction as of Jan 2002.

For instance, we want to find ri,0 , i = 3. Assuming ∆ = 0.5,

σ = 0.0173, and using Table 3 we have:
√
r3,0 = r2,0 + E [r3 − r2 ] + σ × ∆
√
= 5.00% + (2.91% − 2.56%) + 0.5 × 0.0173 = 6.57%
46 P. Kondor Chapter II ⟲
 Interest Rate Tree with prob of up movement: p = 1/2

Time Step 0 1 2 3 4 5 6 7 8 9 10
E[r_i] 1.74 2.17 2.56 2.91 3.22 3.51 3.77 4 4.22 4.41 4.58

Tree Round up to second digit

i 0 1 2 3 4 5 6 7 8 9 10
j 1.74 3.39 5.00 6.58 8.12 9.63 11.11 12.57 14.00 15.42 16.81
1 0.95 2.56 4.13 5.67 7.18 8.66 10.12 11.56 12.97 14.37
2 0.11 1.68 3.22 4.73 6.22 7.67 9.11 10.52 11.92
3 -0.76 0.78 2.29 3.77 5.23 6.66 8.08 9.47
4 -1.67 -0.16 1.32 2.78 4.22 5.63 7.03
5 -2.60 -1.12 0.34 1.77 3.18 4.58
6 -3.57 -2.11 -0.68 0.74 2.13
7 -4.56 -3.12 -1.71 -0.31
8 -5.57 -4.15 -2.76
9 -6.60 -5.21
10 -7.65

Figure 6: Interest rate tree consistent with the predicted interest rate
path in 2001 and p = 1/2

47 P. Kondor Chapter II ⟲
 Risk Neutral Pricing
If we know the risk neutral probability at time i for an up
movement, then the formula of the price at time i in node j is

Vi,j = e −ri,j ×∆ E q [Vi+1 ] (8)

−ri,j ×∆
=e (qi × Vi+1,j + (1 − qi ) × Vi+1,j+1 ) (9)

where ∆ is the time interval between steps.

Therefore, if we know the value of the security at maturity
(e.g., a zero coupon bond must deliver $100) then we can
move backward on the tree using this equation.
One methodology to obtain qi ’s is to use current zero coupon
prices. We can proceed recursively:
1 Start from the bond expiring at time i = 2 to compute q0 (the
bond expiring at time i = 1 does not depend on risk neutral
probabilities, as its value is simply P0 (1) = e −r0 ×∆ × 100)
2 Then given this data, use the bond expiring at time i = 3 to
compute q1 , since we already know q0 this is the only unknown
3 Continue the procedure ...
48 P. Kondor Chapter II ⟲
 Maturity Price Yield
0.5 99.1338 1.74%
1 97.8925 2.13%
1.5 96.1531 2.62%
2 94.1011 3.04%
2.5 91.7136 3.46%
3 89.2258 3.80%
3.5 86.8142 4.04%
4 84.5016 4.21%
4.5 82.1848 4.36%
5 79.7718 4.52%
5.5 77.4339 4.65%
Table 4: Treasury STRIPS on January 8,2002 - Source: The WSJ

49 P. Kondor Chapter II ⟲
 Figure 7: Source: Veronesi (2011), pi∗ stands for qi

50 P. Kondor Chapter II ⟲
 An example: Risk of a Structured Bond
Consider a structured 5-year zero coupon bond, where the
principal repaid at time T = 5 is related to the level of
interest rates
The bond pays at least 94% of the total principal when
interest rates are below 8.55%
When the interest rate increases above 8.55%, the total
principal paid increases proportionally with interest rates
Specifically, V10 = max(11 × 100 × r10 , 94)
What is the fair value of this security? Compare Table 10.14
with 10.13:
The fair value $79.88 is very close to the $79.77, the price of a
standard zero coupon bond
That is, the payoff at maturity is structured so that the lower
principal amount received when the interest rate is low is
compensated by a higher payoff when the interest rate is high

51 P. Kondor Chapter II ⟲
52 P. Kondor Chapter II ⟲
 Pricing and Risk Assessment: the Spot Rate Duration
Numerous structured products have cash-flows which are
dependent on interest rates. Risk managers must be able to
Correctly evaluate the value of such products
Correctly evaluate the risk of the investment.
Although the two tasks are clearly related, they differ in an
important respect:
Pricing (task 1) is performed by using risk neutral probabilities;
Risk assessment (task 2) is performed by using risk natural,
i.e., true, probabilities.
e.g. Take the straddle on the 3-period tree. What is the risk
that a buyer paying V0 for each contract loses more than 50
cents per contract?

53 P. Kondor Chapter II ⟲
 However, it is also useful to introduce a measure of interest
rate risk that is similar to the notion of duration
The spot rate duration measures the percentage sensitivity of
an interest rate security price to the interest rate r and it is
given by:
1 dV
D=− ×
V dr
In a binomial tree we compute it by:
dV V1,u − V1,d
≈
dr r1,u − r1,d

54 P. Kondor Chapter II ⟲
 What is the interest rate sensitivity of this security?
Calculate the spot rate Duration

1 V1,u − V1,d
D=− × =
V r1,u − r1,d
1 79.14 − 83.19
=− × = 2.08
79.88 0.0339 − 0.0095

The same quantity computed for the standard five-year zero

coupon bond is D5 = 4.62: the structured bond is less
sensitive to interest rate risk. Why?
Bond prices decline when interest rate increase. The
structured bond provides protection against this scenario, as it
increases the final payout when the interest rate increases.

55 P. Kondor Chapter II ⟲
 What is the value-at-risk in this security?
We can evaluate the long-term payoff distribution of the
security; for pricing we use risk neutral probabilities, for risk
analysis we use the true, or risk natural, probabilities
Table 10.15 shows the bond payoffs at maturity, and both the
true probabilities and the risk neutral probabilities to obtain
such payoffs
risk neutral probabilities: 69.87% chance of 94, the true
probabilities: 82.81%
risk neutral probabilities:30% a payoff above par , the true
probabilities:17%
risk neutral probabilities make the expectation of future
interest rates higher
Because this structured security pays in a high-interest rate
environment, it is overly optimistic
Any risk analysis, including Value-at-Risk and expected
shortfall, must be performed under the true probabilities
56 P. Kondor Chapter II ⟲
57 P. Kondor Chapter II ⟲
Main points
1 A binomial tree is a simple, but very effective tool to model
and price credit market instruments. However, compared to
derivatives on equities, we need extra steps.
2 In principal, we have three equivalent methods for pricing
constructing a replicating portfolio via no-arbitrage
calculating and using the market price of interest rate risk
risk neutral pricing

58 P. Kondor Chapter II ⟲
 3 Most often we use riks neutral pricing. For this:
i. we need a “realistic” tree of interest rates. In this chapter, we
get it by
predicting increments in short rates and specifying a range of
uncertainty around it, fixing the risk natural probability at
p = 1/2.
ii. we calibrate it to the yield curve by choosing the risk neutral
probability qi accordingly
We start at the shortest maturity zero to get q0 . For every
i = 1, ..., given qi−1 we use zeros with maturity i + 1 to get qi .
iii. Given the interest rate tree and the calibrated risk neutral
probabilities, we can price any derivative, by discounted values
of future cash flows. We start at the end of the tree and
proceed backwards.
4 We can use trees to assess risk.
For the sensitivity of the price to interest rate risk, we use spot
rate duration. This is based on risk neutral probabilities.
For Value-at-Risk type of measures we use risk natural or
physical probabilities.

59 P. Kondor Chapter II ⟲
Appendix I: The Market Price of Interest Rate Risk - Proof
of Eq. (4)
multiply Eq.(2) by p and Eq.(3) by 1 − p and add them up to
get
N1 = (E [V1 ] − N2 E [P1 (2)])/100
Substituting this equation in

V0 = N1 × P0 (1) + N2 × P0 (2)
h i
P0 (1) P0 (1)
we get N2 × E [P1 (2)] × 100 − P0 (2) = E [V1 ] × 100 − V0
V1,u −V1,d
Substitute N2 = P1,u (2)−P1,d (2) to get

e −r0 ×∆ E [P1 (2)] − P0 (2) e −r0 ×∆ E [V1 ] − V0

=
P1,u (2) − P1,d (2) V1,u − V1,d

60 P. Kondor Chapter II ⟲
Appendix II: What is a Value-at-Risk (VaR) measure?
E.g. ”5% Value at Risk is 0.82” means that the risk of any
loss larger than (or equal to) 0.82 is not more than 5%.
(Figure from Wikipedia)

61 P. Kondor Chapter II ⟲
Suggested reading
Tuckman B. and A. Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition, John Wiley & Sons (2011). Chapter 7.

P. Veronesi, Fixed Income Securities: Valuation, Risk, and Risk Management,

John Wiley & Sons (2011). Chapters 9 and 10.

62 P. Kondor Chapter II ⟲
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Brace, A., D. Gatarek and M. Musiela (1997). “The Market Model of Interest
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Cox, J. C., J. E. Ingersoll and S. A. Ross (1985). “A Theory of the Term

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Cox, J.C., S.A. Ross and M. Rubinstein (1979). “Option Pricing: A Simplified
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63 P. Kondor Chapter II ⟲
 Dai, Q. and K.J. Singleton (2000). “Specification Analysis of Affine Term
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64 P. Kondor Chapter II ⟲
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65 P. Kondor Chapter II ⟲