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This article compares empirically the Ho and Lee (1986) and Black, Derman, and Toy (1990) discrete-time debt option pricing models in the pricing of Eurodollar futures options over the period from March 1997 through February 1998 using daily data. The results indicate that both models performed well. The average absolute pricing errors over the sample period were less than one tick (0.01) in every case. The Black, Derman, and Toy model slightly outperformed the Ho and Lee model in the pricing of in-the-money call options and out-of-themoney put options over the period studied. (C) 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 291-306, 1999
(ProQuest Information and Learning: ... denotes formulae omitted.)
INTRODUCTION
The Ho and Lee (1986) model and the Black, Derman, and Toy (1990) model are two competing one-factor binomial models that are useful in the pricing of interest rate contingent claims. These models specify differently how interest rates may evolve over time on a binomial lattice and can give different values to various contingent claims. In this article, the models are used to specify empirically the values of Eurodollar futures options and an analysis of variance is used to compare the performance of the two models in valuing these options.
Eurodollar futures options began trading in March 1985 on the International Money Market of the Chicago Mercantile Exchange (CME). These contracts grant the holder the right to purchase or sell a Eurodollar futures contract at the exercise price prior to the option's expiration date. A Eurodollar futures contract, if held until maturity, calls for the delivery of a 90-day Eurodollar time deposit with a face value of one million dollars.
Eurodollar futures options have several features that make them attractive for use in this study. The Eurodollar futures options market is the most active option market for short-term interest rate-sensitive securities. The underlying deliverable asset, a 90-day Eurodollar time deposit, is essentially a pure discount bond and is not complicated by coupon effects. Eurodollar futures contracts are actually settled in cash; thus there is no need to determine the cheapest-to-deliver security. Moreover, Eurodollar futures option contracts and Eurodollar futures contracts expire concurrently.
REVIEW OF THE MODELS
The Ho and Lee and Black, Derman, and Toy models both describe interest...