FM405E - Fixed Income Securities and Credit Markets 2021/22

The London School of Economics

Problem Set 2
Binomial Trees: Foundations

Consider the binomial interest rate tree below. The time interval is 6 months, hence ri is
semi-annually compounded rate. At t = 0, r0 = 3.99% (annualized), while at t = 0.5, r1,j is
either 4.50% or to 4.00%, with equal (physical) probability. There are two zero-coupon bonds
traded: a 1Y zero with the current price of 0.95974, and a 6M zero.

period i=0 i=1

time (in years) t=0 t = 0.5

r1,u = 4.5% with prob p = 1/2

5

r0 = 3.99%
)
r1,d = 4% with prob 1 − p = 1/2

1. (15 points) What is the implied risk-neutral probability? It must be such that the prices
of all the zeros are matched exactly.

2. (15 points) We may now proceed with pricing derivatives. Consider a call option on the
1Y zero, with expiration date in six months and exercise price equal to 0.9785. What is the
value of this option by risk-neutral valuation?

3. (70 points in total) Now let us consider one additional period. Assume, further, that at
time t = 1, the short-term rate is as in the diagram of Figure 1 below:

4
 r2,uu = 4.9%

q1

r1,u = 4.50%

q0

r0 = 3.99% r2,du = 4.3%

r1,d = 4%

r2,dd = 3.9%

Recall also that each period in the tree equals six months, that is ∆ = 0.5 where ∆ denotes the
time interval between steps. The value for q0 , the risk-neutral probability corresponding to the
first period, was calculated in problem 1. The probability q1 is the risk-neutral probability for
the time-period (0.5, 1), and is taken to be different from q0 . Suppose, also, that an additional
zero is available for trading, a 1.5Y zero. The current price of the 1.5Y zero is P0 (3) = 0.9382.
Let us address the following issues.

a. (20 points) Compute the risk-neutral probability q1 .

b. (25 points) What is the no-arbitrage price of a call option on the 1.5Y zero, with expiration
date in 1Y and exercise price equal to 0.9800?

c. (25 points) What is the no-arbitrage price of a call option on the 1.5Y zero, with expiration
date in six months, and exercise price equal to 0.9580?