Estimating the Binomial Tree.
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u and d Estimation Approach - Equilibrium Model:
Calibration Model - Arbitrage-Free Model:
Where: Su= uS0=S(1+u) or Sd=S(1+d) – the price can go up by u percent or down by d percent.
In a binomial process,
this probability is
t=0 t=1 t=2
t=0 t=1 yr t=2 yr
(1) benchmark interest rates,
(2) an assumed interest rate model, and
(3) an assumed interest rate volatility.