The BDT interest rate model derives the median rates, and time varying volatilities (sigmas) that are used in the construction of the short rate binomial tree. In this course we will walk-through the construction of the short rate binomial tree and then use it to price bonds and options.
We begin by building the complete short rate binomial tree from the BDT model outputs:
We then illustrate how the short rate tree may be used to price a sample 3-year fixed income bond:
Interest Rate Simulation Models: Steps for building Black, Derman and Toy (BDT) model in Excel: How to utilize the results of a BDT interest rate model: Pricing Bonds
Finally we provide an example of how the tree may be used to price a hypothetical European put option on the 3 year bond issue:
Interest Rate Simulation Models: Steps for building Black, Derman and Toy (BDT) model in Excel: How to utilize the results of a BDT interest rate model: Pricing Options