Lattice Models for Pricing American Interest Rate Claims





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    • Li is at the First National Bank of Chicago. Ritchken is at the Weatherhead School of Management, Case Western Reserve University. Sankarasubramanian is at the Debt and Equity Markets Group, Merrill Lynch. We thank the participants of the Fourth Annual Derivative Securities Conference, held at Cornell University in 1994, for helpful comments. We also appreciate the helpful suggestions of an anonymous referee and the editor, René Stulz.


This article establishes efficient lattice algorithms for pricing American interest-sensitive claims in the Heath, Jarrow, and Morton paradigm, under the assumption that the volatility structure of forward rates is restricted to a class that permits a Markovian representation of the term structure. The class of volatilities that permits this representation is quite large and imposes no severe restrictions on the structure for the spot rate volatility. The algorithm exploits the Markovian property of the term structure and permits the efficient computation of all types of interest rate claims. Specific examples are provided.