PT - JOURNAL ARTICLE
AU - Ho, Thomas S.Y.
AU - Lee, Sang Bin
TI - Generalized Ho-Lee Model
AID - 10.3905/jfi.2007.700217
DP - 2007 Dec 31
TA - The Journal of Fixed Income
PG - 18--37
VI - 17
IP - 3
4099 - http://jfi.pm-research.com/content/17/3/18.short
4100 - http://jfi.pm-research.com/content/17/3/18.full
AB - This article presents a multifactor arbitrage-free interest rate lattice model. The model uses a state and time dependent implied volatility function. In calibrating this function from the set of swaption prices over a range of tenors and expiration, the interest rate model can capture surface not just the perceived volatility but the distributional form, in terms of the mix of lognormal and normal distributions, and the correlations of the rates. Swaptions are actively traded in the market that reflects the market views on the yield curve stochastic movements. Interest rate models tend to fix a distributional form or the correlation matrix of the rates, and therefore, they fail to subtract the market views from the swaption prices. This article provides a model that overcomes these crucial assumptions and it can be shown to provide significant explanatory power and computational efficiency. This model interest rate process has a number of desirable properties: (1) Consistent with historical rate experiences, with a mean reversion process, non-explosive rates, and truncated low rates. (2) A binomial recombining lattice provides efficient algorithms for American options and stratified sampling in valuing path dependent securities. (3) Straightforward to specify the multi-factor model and to specify the key rate durations and key rate vegas for risk management. The model is tested in this article empirically using monthly swaption prices over a one year sample period. The results show that the model can be calibrated to the observed swaption prices quite accurately.