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LOS 35.b: Calculate the arbitrage-free value
of an option-free, fixed-rate coupon bond. READING 35: THE ARBITRAGE-FREE VALUATION FRAMEWORK
MODULE 35.1: BINOMIAL TREES, PART 1
EXAMPLE: Arbitrage-free valuation: Sam Givens, a fixed income analyst at GBO Bank, has been asked to value a three-year,
3% annual pay, €100 par bond with the same liquidity and risk as the benchmark. What is the value of the bond using the spot
rates provided below?
But what if this bond was not option-
free: that is, it had an option?
Changes in spot rate will affect its value
and hence the probability of its exercise -
and the underlying cash flows….
We need a model to cope with changes in
rates and underlying CFs flows varying:
One such model, is the
binomial interest rate tree
framework.
As it accommodates probability of option being
exercised; as whether or not to exercise an
option is binomial phenomenon, linked to equal
changes of rates going up or down…
