A Multi-Factor Binomial Interest Rate Model with State-TimeDependent Volatilities, Working Paper

This paper presents a multifactor arbitrage-free interest rate model, based on a binomial lattice framework, that avoids negative and unreasonable high interest rate levels, and the model provides interest rates movement that is consistent with historical interest rate experience. The model is tested 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. The model supports the two-factor model over the one-factor model, and suggests that the implied yield curve movements from the swaption prices are more akin to a normal model than a lognormal model. This interest rate model is specified by a set of difference equations and is therefore simple to implement. The recombining lattice also provides accuracy in pricing a broad range of interest rate contingent claims. For these reasons, the model has many applications in securities valuation, risk management and regulatory compliance