Tree models

Continuous time to discrete

• Tree models allow us to move from continuous time to discrete time.
• Recall the forward rate dynamics:

1 𝑑𝐹 𝑡; 𝑇, 𝑆 = 𝛼 𝑡, 𝐹 𝑑𝑡 + 𝜎 𝑡, 𝐹 𝑑𝑊𝑡

• The discretized version of 1 is:

1
2 Δ𝐹 𝑡; 𝑇, 𝑆 = 𝛼 𝑡, 𝐹 Δ + 𝜎 𝑡, 𝐹 Δ2 𝑧𝑡

• where Δ is the change in time and 𝑧𝑡 ∼ 𝒩 0,1 .

𝑇
• A simple way of discretizing 1 is to use a binomial model, since in the limit as the number of time steps Δ
grows, the binomial distribution converges to the normal distribution:

𝑛 𝑘 𝑛−𝑘
1 𝑘 − 𝑛𝑝 2 𝑇
lim 𝑝 1−𝑝 → exp − , 𝑝 ∈ 0,1 , 𝑛=
𝑛→∞ 𝑘 2𝜋𝑛𝑝 1 − 𝑝 2𝑛𝑝 1 − 𝑝 Δ
Continuous time to discreet (cont.)
• A convenient property of tree models, however, is that there is a node
at each time step.
• If an option is American in style (can be exercised at any time step prior to
maturity), then tree methods are useful.
• If a derivative is path dependent, such as Asian options, then tree methods
are useful.
• If there are time varying parameters, then tree models are also useful.
• Essentially, tree models are a discretization of the continuous-time
evolution of an asset, which also allow us to price payoffs, which do
not have a closed form solution.
• Such as an American option, for example.
One-period binomial tree
• A one-period binomial tree only has 1 time step:
𝑟0 𝑟1,𝑢
𝑟1,𝑑

• where 𝑟0 is the current interest rate, 𝑟1,𝑢 is the interest rate if there is an up
step, and 𝑟1,𝑑 is the interest rate if there is a down step.
• The probability of an up move is 𝑝 and the probability of a down move is
1−𝑝
• Note that we are modeling the short rate in this tree model.
• Since there can’t be arbitrage along the term structure, we are implicitly
assuming that all interest rates along the term structure are perfectly
correlated.
• Therefore, if the fed changes the short rate, then the whole term shifts in perfect
correlation (this is what they hope happens).
One-period tree (Example)
• As a simple example, assume that the current
1
short rate is 2.389% and that it has a volatility of
26%. The time step Δ is 1 month (Δ = 12). Assume that the short rate is a martingale (𝛼 = 0).
• We know that the solution to 1 (a geometric Brownian motion) with constant coefficients is:

𝜎2
𝐹 𝑡; 𝑇, 𝑆 = F 0; 𝑇, 𝑆 exp 𝛼− ⋅ 𝑡 + 𝜎 ⋅ 𝑊𝑡
2

1
• Therefore, we can discretize the short rate by letting 𝑢 = exp 𝜎 Δ and by letting 𝑑 = 𝑢 =
exp −𝜎 Δ and setting the probabilities such that

𝑝 ⋅ 𝑢 + 1 − 𝑝 ⋅ 𝑑 = exp 𝛼 ⋅ Δ ,

exp 𝛼 ⋅ Δ − 𝑑
𝑝=
𝑢−𝑑
One-period tree (Example, cont.)
• The tree is then:
1
𝑟0 = 2.389 𝑟1,𝑢 = 𝑟0 𝑢 = 2.389 ⋅ 𝑒
0.26 12
= 2.575
1
−0.26 12
𝑟1,𝑑 = 𝑟0 𝑑 = 2.389 ⋅ e = 2.216

• The real world probability of an up move is then:

0.26 2 1 1
0− ⋅ −0.26
𝑒 2 12 −𝑒 12
𝑝= = 0.462525
1 1
0.26 −0.26
𝑒 12 − 𝑒 12

• 𝔼 𝑟1 = 𝑝 ⋅ 2.575 + 1 − 𝑝 ⋅ 2.216 = 2.382.

0.26 2 1
• 𝔼 𝑟1 = 2.389 ⋅ exp 0− ⋅ = 2.382
2 12
Multi-period binomial trees (recombining)
• Multi-period binomial trees are simply a sequence of 1-period trees:
𝑟0 𝑟1,𝑢 𝑟2,𝑢2 𝑟3,𝑢3
𝑟1,𝑑 𝑟2,𝑢𝑑 𝑟3,𝑢2 𝑑
𝑟2,𝑑2 𝑟3,𝑢𝑑2
𝑟3,𝑑3

• The number of paths that result in a node is given by Pascal’s triangle.

𝑟0 1 1 1
1 2 3
1 3
1
Multi-period binomial trees (cont.)
• Keep 𝑇 fixed and keep reducing Δ to get more steps in the tree. For
example (𝑇 = 1):
1 1 1
• 1 = 1/1, 2 = 1 , 3 = 1 , 4 = 1 , …
2 3 4
• As Δ → 0, 𝑛 → ∞ and the tree distribution converges to the distribution of
the continuous-time stochastic process.
• Note, the upper triangular matrix of the tree. This is how we will want to
write the tree it into the computer.
• 1-step probabilities, expected returns, and variances do not change in this
framework.
• For time varying values, it would be appropriate to use a multi-tree multi-period
approach.
• A tree for each of the time varying parameters and then a tree for the asset.