We have derived the two-factor binomial model. The model has a closed-form
solution , the Markovian property, the mean reversion property with time-varying
reversion coefficient. It can fit both the current yield curve and the current term
structure of volatility at the same time. On top of these characteristics, we can
easily extend it to a N-factor model.
As empirical results of principal component analysis have shown, we need more than
one factor to describe possible term structure movements. In this sense, we should
develop the two-factor term structure model to price complicated interest contingent
claims.
For further research, we should investigate empirical validity of the two-factor
binomial model as compared to the one-factor binomial models. In addition to this,
we should examine what additional properties we can get from the time-state
dependent volatility model in contrast to time dependent volatility model.
