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LOS 35.f: Compare pricing using the zero-coupon yield
curve with pricing using an arbitrage-free binomial lattice. READING 35: THE ARBITRAGE-FREE VALUATION FRAMEWORK
EXAMPLE: Same date: based on the MODULE 35.2: BINOMIAL TREES, PART 2
table as we saw before for a 3-year,
3% annual-pay Treasury bond: Compute the value of the $100 face value option-free bond.
But we said, if this bond has embedded options changes in future
rates, S1, S2 and S3 will affect the probability of its exercise - and
hence, the underlying cash flows….
Hence we need a binomial interest rate tree framework to cope with
Why same? bond pricing of this nature.
Underlying interest
rate tree was
calibrated (using
lognormality) to
generate arbitrage-
free values
consistent with the
benchmark!
