Ho Lee Model

The Ho-Lee model improves upon the drift to incorporate time-dependency which means that the drift in time 1 will be different than the drift in time 2. Further, each drift at time t does not have to increase and may even be negative.

$ dr\, = \, \lambda _{t}\, dt\, +\, \sigma \sqrt{dt} $

Why is Ho Lee Model Important?

λ1 and λ2 are estimated from observed market prices. In other words, r0 is the observed one-period spot rate. λ1 could then be estimated so that the model rate equals the observed two-period market rate. λ2 could be calibrated from using r0 and λ1 and the observed market rate for a three-period security.