Abstract
No-arbitrage interest rate models are designed to be consistent with the current term structure of interest rates. The diffusion of the interest rates is often approximated with a tree, in which the scenario-dependent fair price of any security is calculated as the present value of the risk-neutral expectation by backward induction. To use this tree in a portfolio optimization context it is necessary to account for the so-called "market price of risk". In this paper we present a method to change the conditional probabilities in the Black-Derman-Toy model to the physical (or real) measure, including the market price of risk, and explore the economic implications for expected spot rates and for expected bond returns. © 2009 Elsevier B.V. All rights reserved.