Skewness-Adjusted Binomial Interest Rate Models

Abstract

In this paper, we illustrate how a skewness-adjusted binomial model can be used to calibrate a binomial interest rate tree for increasing and decreasing interest rate cases. We then show how the implied yield curves and implied forward rates generated from the model result in flat, normal, and inverted yield curves that are consistent with the end-of-the-period distribution. We conclude the paper by showing how skewness can be incorporated into the Black, Derman, and Toy (BDT) calibration model and showing the possible mispricing that can result when the BDT variability conditions are not adjusted to reflect skewness.