Binomial Models for Interest Rate Derivatives

We shall discuss the construction of simple binomial models for pricing interest rate derivatives The main feature of these models is that the risk free interest rate can vary stochastically from one period to the next Stochastic rate models can be used to price interest rate options caps and oors options on bonds callable bonds etc They can also be incorporated at the expense of more complexity into a model that prices derivatives contingent on one or more traded assets e g equity indices currencies in an environment with changing interest rates This point of view is important for instance for pricing long term options or other instruments in which changes in the costs of funding may have signi cant impact on pricing