Interest rate derivatives: Pricing of Euro-Bund options : An empirical study of the Black Derman & Toy model (1990)

The market for interest rate derivatives has in recent decades grown considerably and the need for proper valuation models has increased. Interest rate derivatives are instruments that in some way are contingent on interest rates such as bonds and swaps and most financial transactions are in some way exposed to interest rate risk. Interest rate derivatives are commonly used to hedge this risk. This study focuses on the Black Derman & Toy model and its capability of pricing interest rate derivatives. The purpose was to simulate the model numerically using daily Euro-Bunds and options data to identify if the model can generate accurate prices. A second purpose was to simplify the theory of building a short rate binomial tree, since existing theory explains this step in a complex way. The study concludes that the BDT model have difficulties valuing the extrinsic value of options with longer maturities, especially out-of-the money options