The Black, Derman and Toy One-Factor Interest Rate Model

Black, Derman and Toy (BDT) [6] make use of a binomial tree approach to model interest rates in a discrete time framework. The model has one fundamental factor, the short-term interest rate, which is used to determine all rates and security prices. The current term structure of interest rates and related volatilities are used to construct a binomial tree of possible shortterm interest rates in the future. Since an interest rate sensitive security is characterised by its payoff at expiry, the constructed tree of possible interest rates is used to determine the current price of a security by means of an iterative procedure.