
Explanation:
In the Ho-Lee model, the interest rate tree follows a binomial structure where:
From the given tree:
We need to find the missing node [2,0] (the down-down state).
Step 1: Calculate the volatility Ο
The difference between up and down states at time 1: 4.661% - 3.506% = 1.155%
Since this is a one-period difference, and in Ho-Lee model the spacing between nodes is ΟβΞt: ΟβΞt = 1.155%
Assuming Ξt = 1 month = 1/12 year: Οβ(1/12) = 1.155% Ο = 1.155% Γ β12 β 1.155% Γ 3.464 = 4.0%
Step 2: Find the missing node [2,0]
From the down state at time 1 (3.506%), the down movement should be: r[2,0] = r[1,1] - ΟβΞt = 3.506% - 1.155% = 2.351%
However, this doesn't match any options exactly. Let's verify using the tree structure:
From the given nodes:
So: r[2,0] = r[2,1] - 1.155% = 4.15% - 1.155% = 2.995%
This matches option C.
Verification: The tree maintains constant volatility with equal spacing between adjacent nodes at each time step, confirming that 2.995% is the correct value for the missing node [2,0].
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Ho-Lee Model: Time-dependent drift
dr = Ξ»βdt + Οdw
r(0) = 4%
Month 1 β 4.661% β Month 2 β 5.305% β 3.506% β 4.15% β ?
What is the value of the missing node [2, 0] in this Ho-Lee interest rate tree?
A
2.447%
B
2.677%
C
2.995%
D
3.256%