Libo-on, Joannalyn M.

FINOPVA

K32

June 11, 2014

11130040

Black Derman Toy Model

Interest rates are one of the major drivers in the bond market, stock market
and the foreign exchange market due to the fact they influence the investment
decisions of the investors. In the world of finance, experts are continuing to introduce
models that would value interest rate sensitivity security. In 1980s, Black-Derman
Toy Model was introduced by Fischer Black, Emanuel Derman, and Bill Toy, by
establishing the expectations of all interest rates using a one-factor model which a
stochastic factor known as the short rate. Even though, Black, Derman and Toy
introduced the model, it was first improved for in-house use by Goldman Sachs and
at some point published in the Financial Analysts Journal in 1990. The BlackDerman-Toy model is mostly dependent to only one factor, which is the short rate,
since the model used the short rate in constructing a tree that can be used to value
securities that are interest rate sensitive. Using the current structure of long rates
and their estimated volatilities, the model can construct a tree of probable future
short rates. The Black-Derman-Toy model is important in valuing bond options
because the model can determine the future prices of the bonds at various points
and in return, the model can also be used to determine the options value at
expiration. The Black-Derman Toy model was derived from the evolution of the yield
curve model that was proven to be favored by the practitioners for valuing interest
rate derivatives. The single factor used in the model known as the short rate is an
annualized one-period interest rate that was applied in the valuation of security
prices. Some of the underlying assumptions provided by the Black-Derman-Toy
model are:

Expected returns on all securities over one period are equal.

Changes in all bond yields are perfectly correlated.

There exists no taxes or transaction costs.

The assumption in the model that the short are log-normally distributed is
advantageous because the results of model for the interest rates will always be
positive. In one of the assumptions provided by the model that the changes in all
bond yields are expected to be perfectly correlated due to the reason that the model
is only using a single factor that it is presume that the uncertainty in the short rates is
the only thing assumed to affect the rates of different maturities.

The short-rate volatility is prospectively time dependent, and the continuous process
of the short-term interest rate given by the Black-Derman Toy Model is:

wherein:
r = the instantaneous short rate at time t
= value of the underlying asset at option expiry
= instant short rate volatility
Wt = a standard Brownian motion under a Risk-neutral probability measure;
its differential.

Applying the Black-Derman-Toy model in valuing options

has many

advantages. One of its advantages is that the volatility used in the model is a
percentage unit, which conforms to the market convention. This popular model is
favored by the experts because of its good estimate of predicting the future interest
rates. The model surmises that the short-term rates revert to their mean and has a

normal logarithmic distribution.

The Black-Derman-Toy model integrates two

independents of time in order for the model to fit the term structure of spot interest
rates and the term structure of spot rate volatilities. The no-arbitrage model was
formulated so that it is exactly constant with the term structure of interest rates that is
observed in the market. The model has an advantage that it can be easily be
represented in the form of a binomial tree but in order for the model to be able to
constitute the formation of a binomial tree, it was presumed that the interest rates
that would be using are compounded annually.

The Black Derman Toy model has 3 essential features:

The model fluctuates an array of means and an array of volatility

changes, the future volatility changes, and the future mean reversion
changes.

The structural variable of the model is the short rate, which is the
annualized one-period interest rate that acquires all the security prices.

The mode derives model takes as inputs an array of long rates, which
is the yield on zero-coupon bonds for diverse maturities, and array of
yield volatilities for the same bonds. The first array is known as the
yield curve while the second array is called as the volatility curve and
jointly these curves form the term structure.

REFERENCE:

Black-Derman-Toy Model. (n.d.). TheFreeDictionary.com. Retrieved June 11,

2014, from http://financial-dictionary.thefreedictionary.com/Black-DermanToy+Model

BlackDermanToy model. (2014, May 26). Wikipedia. Retrieved June 11,

2014, from http://en.wikipedia.org/wiki/BlackDermanToy_model
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http://belkcollegeofbusiness.uncc.edu/wtian1/bdt.pdf

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http://savage.wharton.upenn.edu/FNCE934/syllabus/papers/Black_Derman_Toy_FAJ_90.pdf
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http://prosoftware.se/stud/II2008/BDT.pdf
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http://www.seasholes.com/files/Klose_Yuan_2003_WP.pdf
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http://financetrainingcourse.com/education/2010/10/interest-rate-models-blackderman-and-toy-bdt-building-bdt-in-excel-introduction/
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