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Practical Illustration:

Option pricing in Ho and Lees lattice.


We want to price a put option, with maturity of 1 year and
strike price $980 on a 3-month T-Bill with face value equal to
$1000.
This option gives the right to the owner to sell at date t = 1 a
T-bond paying $1000 at date t = 1.25.
We consider t = 0.25 (3 months).
Therefore, there will be four sub-periods during the life of
the option (T = 1,2,3,4).
We first start from the initial structure which we derive, as usual,
from prices:
B(0,1) = 0.9826
B(0,2) = 0.9651
B(0,3) = 0.9474
B(0,4) = 0.9296
B(0,5) = 0.9119
We take as given the values of and :
=

= 0.997
1

We now use
h(u ) =

1
+ (1 ) u

and

h * (u ) = u h(u )
For example,
h(1) =

1
= 1.0015
0.5 + 0.5(0.997)

h * (1) = 0.997 1.0015 = 0.9985


Finally, we get
u
h(u)
h*(u)

1
1.0015
0.9985

2
3
4
5
1.0030 1.00451 1.00601 1.00751
0.9970 0.99549 0.99399 0.99249

We then use
Bi +1 (n + 1, u + n + 1) =

Bi (n, u + n + 1)
h(u )
Bi (n, n + 1)

and
Bi (n + 1, u + n + 1) =

Bi (n, u + n + 1)
h * (u )
Bi (n, n + 1)

to get (starting from the initial term structure on the first line):
u
B (0,u)

1
0.98260

2
3
0.96510 0.94740

4
0.92960

B0 (1,1+u)
B1 (1,1+u)

0.98071
0.98367

0.96128 0.94180
0.96707 0.95032

0.92247
0.93362

B0 (2,2+u)
B1 (2,2+u)
B2 (2,2+u)

0.97871 0.95743 0.93637


0.98165 0.96320 0.94485
0.984612 0.96901 0.95340

B0 (3,3+u)
B1 (3,3+u)
B2 (3,3+u)
B3 (3,3+u)

0.97679
0.97973
0.98268
0.98563

B0 (4,4+u)
B1 (4,4+u)
B2 (4,4+u)
B3 (4,4+u)
B4 (4,4+u)

0.97506
0.97800
0.98094
0.98389
0.98685

5
0.9119

0.95387
0.95961
0.96540
0.97122

For example, we have (for u = 1)

0.98367 =

0.9651
1.0015
0.9826

0.98071 =

0.9651
0.9985
0.9826

Then, we compute that the payoff of the put at maturity is given


by (for i = 0,1,2,3,4)

Pi (4) = max(980 1000 Bi (4,5),0)

Hence, we get the following tree:


0.00 = (980-986.85)+
0.00
0.00 = (980-983.89)+

0.00
0.24
0.75

0.00
0.00 = (980-980.94)+

0.48
1.29

0.98
2.00 = (980-978.00)+

2.14
3.41

4.94 = (980-975.06)+

where we have applied the recursive rule


Pi (n) = (1 / 2 Pi +1 ( n + 1) + 1 / 2 Pi (n + 1) )Bi (n, n + 1)

Finally, we get
P (0) = 0.7471 0.75

Limits of the method.


- Interest rates can take on negative value with positive
probability.
- Volatility of interest rates is constant for all n (time constant)
and all T (maturity constant).
- All the zero-coupon yield curves for all future dates are parallel.
- The term structure dynamics is driven by a single factor, namely
the short-term interest rate.

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