PT  - JOURNAL ARTICLE
AU  - Grzegorz Krzyżanowski
AU  - Ernesto Mordecki
AU  - Andrés Sosa
TI  - Zero Black-Derman-Toy Interest Rate Model
AID  - 10.3905/jfi.2021.1.122
DP  - 2021 Nov 12
TA  - The Journal of Fixed Income
PG  - jfi.2021.1.122
4099  - https://pm-research.com/content/early/2021/11/11/jfi.2021.1.122.short
4100  - https://pm-research.com/content/early/2021/11/11/jfi.2021.1.122.full
AB  - We propose a modification of the classical Black-Derman-Toy (BDT) interest rate tree model, which includes the possibility of a jump with a small probability at each step to a practically zero interest rate. The corresponding BDT algorithms are consequently modified to calibrate the tree containing zero interest rate scenarios. This modification is motivated by the recent 2007–2008 crisis in the United States and it quantifies the risk of future crises in bond prices and derivatives. The proposed model can be useful to price derivatives. A comparison of option prices and implied volatilities on US Treasury bonds computed with both the proposed and the classical tree model is provided in six different scenarios along the different periods comprising the years 2002–2017.Key Findings▪ The modification of the classical Black-Derman-Toy model reflecting the Zero Interest Rate Policy is proposed.▪ The empirical analysis corresponding to the period 2002-2017 is presented.▪ The novel model returns more accurate option prices in pre crisis period than its classical equivalent.