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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