FINOPVA K31

CADSAWAN, Lore-Anne A.

Prof. Tommy Tiu

September 24, 2014
Black-Derman-Toy Model

Hull (2014) described the Black-Derman-Toy Model as a specific case of the more
popular mathematical model, of an interest rates term structure, constructed by Black and
Karasinski since both models short rate follows a mean-reverting lognormal process. The one
thing that distinguishes the former is through the construction of its binomial tree, which
determines the relationship between two very important terms, reversion rate and short rate
volatility. Simply put, the Black-Derman-Toy Model makes use of short term interest rates and
constructs a binomial tree in order to create a structure which is adaptable enough to match
certain data. An example of which can be market information on bonds, such as bond prices, the
annual effective yield to maturity, and the volatility of the said yield, that needs matching. And as
a result, the model generates apparent arbitrage opportunities such as unmatched observed
prices with theoretical prices. (Cudina, 2013)
In creating the BDT model, an arbitrage-free world was assumed and considered as its
market-model, thus not all present prices in the real world are included. Moreover, only a small
amount of parameters was used through estimating observations. The model also utilizes the
calibration technique in order to accurately match the model to the given data. Specifically, there
are two ways of calibrating the BDT model, namely the short rate volatility method and the yield
rate volatility method. These two modes have one thing in common: it uses the current term
structure of zero-coupon bond prices. However, the short rate volatility method utilizes the
term structure of short rate volatilities while the yield rate volatility method makes use of the
term structure of yields on zero-coupon bonds (Boyle, Tan, Tian, 2001).
Delving further into the model, there are two essential parameters that will be of help to
match the data with the constructed tree. These parameters are the rate level parameter at a given
time, and the volatility parameter. To start constructing the BDT tree, three major steps must be
followed, and these are:

Step 1: Measurement of volatilities

Step 2: Verification the data to be plugged into the tree
Step 3: Matching through construction of the BDT tree
After familiarizing with the various terminologies, the first step of creating the BDT can
now commence. To start off, let the annualized yield of the bond be:
1
(T h )

y [ h ,T ,r ( h ) ] =P[h ,T , r ( h ) ]

where

y [ h ,T ,r ( h ) ] is the annualized yield of the bond,

P[h ,T , r ( h ) ] is the price of a zero-coupon bond maturing at time T ,
h is the time of acquisition of the zero-coupon bond,

is the time the zero-coupon bond matures, and

r ( h ) is the short term rate of the zero-coupon bond at time h .

Also, assuming that the short term rate,

r ( h ) , can take on two values at time

h , the

annualized lognormal yield volatility becomes:

1
2 h

ln

y (h , T , ru )
y ( h ,T ,r d )

where

ru

and

rd

are the two values the short term rate can take on at time h .

The second step in the construction of the BDT tree is the data verification. By entering
the chosen data, which utilizes 1-year effective annual rates, into the tree, the authentication of
the BDT tree with the data will begin. With the verification process done, the construction of the

BDT tree starts by creating nodes that are seen to progress outward. The very first node has a 1year rate of
P 0=

R0

and a 1-year bond price of

P0

such that:

1
(1+ R0 )

The second node denotes the price of the 1-year bond by

P(1,2, r u)

As mentioned above, the short term rate can make use of two values

ru

and

or
rd

P(1,2, r d ) .
depending

on the interest rates movement. Furthermore, the second node requires two consistency
requirements to be met in order for it to process, and these are:
P 1=

1
1
1
P ( 1,2,r u )+ P ( 1,2, r d )
(1+ R0 ) 2
2

1
1
1
+
2
(1+ R0 ) 2(1+ R 1 e ) 2(1+ R1 )

R e2
1
R0= ln 1
2
R1

( )
1

References
Boyle, P., Tan, K., & Tian, W. (2001). Calibrating the Black-Derman-Toy model: Some
theoretical results. Applied Mathematical Finance 8, 27-48 (2001).
Cudina, M. (2013). A binomial interest rate model and the Black-Derman-Toy Model.
Retrieved

on

September

22,

2014

from

https://www.ma.utexas.edu/users/mcudina/Lecture24_4and5.pdf
Cudina, M. (2013). Lecture 2: Black-Derman-Toy. Retrieved on September 22, 2014 from
https://www.ma.utexas.edu/users/mcudina/m339w_lecture_two_BDT.pdf
Hull, J. (2014). Options, futures, and other derivatives: Technical Note No. 23 on the Black,
Derman, and Toy Model. (9th edition). Upper Saddle River: Prentice Hall.