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Ho/Lee (1986) Model

Ho/Lee (1986) Model

The Ho/Lee (1986) model is able to match the initial term structure of interest rates in the model to the term structure currently observed on the financial market. This article describes the assumptions as well as the main parameters of the model. Moreover, the general model structure as well as the evolution of the zero-coupon bond prices in all future nodes are described. The article precisely shows how the future bond prices can be modelled, departing from today's term structure, by means of the no-arbitrage condition, the path-independence condition, the Ho/Lee parameters and maturity-dependent "perturbation functions". This is also illustrated using a numerical example. The article also mentions briefly how to estimate the parameters of the model. One more focus is on the advantages and disadvantages of the Ho/Lee model. The final part deals with models that are closely related to the Ho/Lee model (e.g. Heath/Jarrow/Morton models) as well as with several applications of the model (e.g. pricing of interest rate derivatives including real options).