Trinomial tree

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Trinomial tree

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12 February 2008

The model is

drt = ((t) rt )dt + dwt ,

so that

rt = et r0 +

Z t

0

e(ts) (s)ds +

a(t) + et Xt ,

Z t

0

e(ts) dws

(1)

Xt =

Z t

0

es dws .

The tree models Xt . The final maturity time is T years, and there are M time steps per year,

so the discrete time increment is = 1/M with a total of T M steps. The spatial step is h. If

we take

(2)

h = 3

and up and down probabilities equal to 1/6, then the trinomial step matches the first 5 moments

of the normal distribution N (0, 2 ). Here Xt does not have stationary increments, so we let 2

be an average variance, defined by

2 =

2 2T

1

1) = E[XT2 ] 2 b2 .

(e

2T

T

Thus

h = 3b2 .

Now

2

E(Xt+ Xt )

Z t+

e2s ds

2 e2t 2

=

(e 1)

2

= t2 ,

so

t2 = 2 e2t b1 ,

where

1 2

(e 1).

2

To match the incremental variance at time t = k, and recalling that h is given by (2), the up

and down probability pk must satisfy 2pk h2 = t2 , from which we find

b1 =

pk =

1 b1 2k

e

.

6 b2

Let us denote the discrete-time process on the tree by (Yk ), so that Yk {jh : k j k}.

We want to ensure that the tree correctly calculates the zero-coupon bond values

1 k T M,

Bk = p(0, k),

(3)

which are todays market data. Index the nodes at time k as (k, j) where k j +k. In

(1) we take a(t) to be piecewise constant: a(t) = ak , t [k, (k + 1)[. We thus have T M

constraints to determine the T M values a0 , . . . , aT M 1 . This is done by a forwards induction

procedure involving the so-called Arrow-Debreu prices qk,j . The price qk,j is the value at time 0

of a contract that delivers $1 if Yk = jh and zero otherwise. The calibration condition is thus

Bk =

k

X

qk,j ,

k = 1, . . . , T M.

j=k

(Of course, B0 = q0,0 = 1.) At node (k, j) the short rate is, from (1), ak + ek jh. We interpret

this as the period- rate set at time k, so the discount factor for the period [k, (k + 1)] when

Yk = jh is

1

1

k

1 + (ak + e

1 + k + jk

jh)

We recursively compute the coefficients k and the Arrow-Debreu (AD) prices, and then we

throw away the latter. They are not needed subsequently. Note that the k are known.

At time k = 0, the discount factor is 1/(1 + 0 ), so

B1 =

1

,

1 + 0

0 =

1

1.

B1

q1,1 = q1,1 =

p0

,

1 + 0

q1,0 =

(1 2p0 )

.

1 + 0

Suppose we have determined 0 , . . . , k1 and all the AD prices qk,j , at some time index k.

Then the next ZCB price is

k

X

qk,j

Bk+1 =

.

(4)

1 + k + jk

j=k

The right-hand side of (4) is a monotone decreasing function of k , so we can determine the

unique value of k satisfying (4), by a binary search procedure.

If we consider a node (k+1, j) with k+1 j k1, then Yk+1 = j only if Yk = j1, j, j+1.

The AD price for (k + 1, j) is therefore

qk+1,j =

pk qk,j1

(1 2pk )qk,j

pk qk,j+1

+

+

.

1 + k + (j 1)k

1 + k + jk

1 + k + (j + 1)k

There are similar expressions for the boundary cases j = k 1, k, k, k + 1. The order of

business is thus to use the above expressions to compute 0 q1, 1 q2, . . . T M 1 .

This completes calibration to market zero-coupon bond prices.

Calibration of the volatility parameters , must use volatility-sensitive market data, i.e.

cap or swaption prices.

2

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