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Assume that the continuously-compounded spot yields curve is as follows: r(0,0.5)=1.2%, r(0,1)=1.6%, r(0,1.5)=2%, r(0,2)=2.2%. a....

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Finance

Assume that the continuously-compounded spot yields curve is as follows:

r(0,0.5)=1.2%, r(0,1)=1.6%, r(0,1.5)=2%, r(0,2)=2.2%.

a. Assume that the drift parameters in a Ho-Lee model are equal to 0.01 for i=0,1,2, and the volatility parameter is equal to 1.5%. Build a three-step interest-rate tree with =0.5. Use this Ho-Lee model to calculate the model-implied price of a 0.5-year,a 1-year, a 1.5-year and 2-year zero coupon bond. Do these pieces agree with the observed spot yield curve?

b. Fit the drift parameter ( i=0,1,2) in the previous Ho-Lee model so that the model matches the observed spot yield curve perfectly. What are the values?

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