Pricing Eurodollar futures options using the BDT term structure model: The effect of yield curve smoothing

This article focuses on pricing Eurodollar futures options using the single-factor Black, Derman, and Toy (1990) term structure model with particular emphasis on yield curve smoothing. Of the various approaches, the maximum smoothness forward rate approach developed by Adams and van Deventer (1994), cubic yield spline, and linear interpolation are used to produce finely spaced binomial trees. We compare the pricing accuracy associated with the use of yield curve smoothing techniques within the BDT framework. The findings provide the first supporting evidence that using a forward rate curve with maximum smoothness together with a time-varying volatility structure improves best the performance of the BDT model. The empirical results are found to be robust across factors affecting the option price such as time-to-expiration. moneyness, and trading volume. (C) 2000 John Wiley & Sons, Inc.