A Closed-Form Multifactor Binomial Interest Rate Model

Abstract

A number of binomial interest rate models have found broad application in valuing interest rate-contingent claims. While researchers are seeking to extend the one-factor model to multifactor models, so far all multifactor models are non-recombining interest rate models, which are not as accurate in valuing securities calibrated to market prices. The multifactor closed-form binomial interest rate model proposed here is simple to implement and can capture a broad range of interest rate movements that are arbitrage-free. Empirical evidence supports the robustness of the model, which can be calibrated to 70 at-the-money swaptions with under 1.3% average error.