L6 - Ch. 8 Interest Rate Trees and Arbitrage-Free Valuation

L6.
1 The Arbitrage-Free
Valuation Framework
From: AS, Ch. 8
1. Introduction
 The idea that market prices will adjust until there are no opportunities
for arbitrage underpins the valuation of fixed income securities,
derivatives, and other financial assets.
 Valuation tools must produce a value that is arbitrage free.

2. The Meaning of Arbitrage-free Valuation (from
AS, Ch. 8, Section 2)
 Arbitrage-free valuation refers to an approach to security valuation
that determines security values that are consistent with the absence of
arbitrage opportunities, which are opportunities for trades that earn
riskless profits without any net investment of money.
 In well-functioning markets, prices adjust until there are no arbitrage

opportunities, which is the principle of no arbitrage that underlies the
practical validity of arbitrage-free valuation.
2. The Meaning of Arbitrage-free Valuation (from
AS, Ch. 8, Section 2)
 2.3 Implications of Arbitrage-Free Valuation for Fixed-Income Securities
 Using the arbitrage-free approach, a fixed income security should be thought of as a package or
portfolio of zero-coupon bonds.
 The market mechanism for US Treasuries that enables this approach is the dealer’s ability to
separate the bond’s individual cash flows and trade them as zero-coupon securities. This
process is called stripping. In addition, dealers can recombine the appropriate individual zero-
coupon securities and reproduce the underlying coupon Treasury. This process is called
reconstitution.
 The arbitrage-free valuation approach does not allow a market participant to realize an
arbitrage profit through stripping or reconstitution. By viewing any security as a package of
zero-coupon bonds, a consistent and coherent valuation framework can be developed.
3. Interest Rate Trees and Arbitrage-Free Valuation
 For bonds that are option-free, the simplest approach to arbitrage-free
valuation involves determining the arbitrage-free value as the sum of
the present values of expected future values using the benchmark spot
rates.
 Example 2 (from AS Book, pp. 401-402): The Arbitrage-Free Value of an Option-Free Bond
 The YTM (par rate) for a benchmark 1-, 2-, and 3-year annual pay bond is 2%, 3%, and 4%,
respectively.
 (A) Compute the bond price with the DCF approach for a 3-year, 5% coupon, annual-pay bond with the
same risk and liquidity as the benchmarks;
 (B) Is this value correct for the bond given the current structure?
 Solution:
 (A). The bond price as computed with the DCF approach:
 +


 (B) If this bond is priced with the arbitrage-free approach (with spot rates):
 Step 1: Find the correct spot rate foe each year’s cash flow using a bootstrapping method:
 +…+
 In the example, one-year spot rate z1 is 2.00%, solve for z2:
 to get z2 = 3.015%
 To solve for z3:
 + to get z3 = 4.055%
 Step 2: The correct arbitrage-free price for the bond is:
 The bond is mispriced by 0.0351 (102.8102 vs. 102.7751) per 100 of par value.
 Arbitrage: Buy the bond and strip each coupon and principle to issue and sell 3 zero coupon bonds: a 1-year
zero that pays $5 at maturity, a 2-year zero that pays $5 at maturity, and a 3-year zero with $105 maturity
value:
Period Cash Flow Price Paid Price Received Arbitrage Profit
1 5 4.8077 4.902 0.0943
2 5 4.6228 4.7116 0.0888
3 105 93.3446 93.1967 -0.1479
Total 102.7751 102.8102 0.0351
 Price paid to buy the bond = 102.7751

 Price received from selling zero bonds = 102.8102
 Arbitrage profit = 0.0315
 With the arbitrage, bond price will rise, and zero-coupon bond price will fall, at the end the price paid and
price received from stripping and reconstitution will be equal, and the arbitrage profit is eliminated.
 For option-free bonds, performing valuation discounting with spot rates produces an arbitrage-free
valuation. Changes in interest rates have no impact on the size and timing of the cash flows
(coupons and principal).
 For bond with options attached, changes in future interest rates impact the likelihood the option will
be exercised and in so doing impact the cash flows. To value such bonds, we must allow interest
rates to take on different potential values in the future based on some assumed level of volatility.
 The vehicle to portray this information is an interest rate “tree” representing possible future interest
rates consistent with the assumed volatility.
 The interest rate tree performs two functions in the valuation process:
 (1) generate the cash flows that are interest rate dependent and
 (2) supply the interest rates used to determine the present value of the cash flows.
 An interest rate model seeks to identify the factors that explain the dynamics
of interest rates. These factors are random or stochastic in nature and cannot
predict the path of any particular factor. An interest rate model must therefore
specify a stochastic process that describes the stochastic property of these
factors in order to arrive at a reasonably accurate representation of the
behavior of interest rates.
 The task here is to build a binomial interest rate tree framework, specifically a binomial
lattice model – describing the path of interest rates that can take on one of two possible
values consistent with the volatility assumption and an interest rate model. The two
possible interest rates next period will be consistent with the following three conditions:
 (1) an interest rate model that governs the random process of interest rates,
 (2) the assumed level of interest rate volatility, and
 (3) the current benchmark yield curve.
3.1 The Binomial Interest Rate Tree
 In a binomial interest rate tree, at each node there is a random event of
changing interest rates. When use the binomial interest rate tree to
determine the value of a bond with an embedded option, at each node
there will be a decision.
 A valuation model involves generating an interest rate tree based on

 (1) benchmark interest rates,
 (2) an assumed interest rate model, or
 (3) an assumed interest rate volatility.
 The assumed volatility of interest rates incorporates the uncertainty

about future interest rates into the analysis.
An example of a Binomial Interest Rate Tree:
How the interest rate will go to the next
period depends on:
(1) the benchmark interest rate, Because we are determining
(2) the interest rate model, and how interest rate will move to
(3) the interest volatility 𝑟 2, 𝐻𝐻 =7.65% the next period, say from t=2 to
t=3, one-period forward rates
are projected.
𝑟 1 , 𝐻 =4.89 %
𝑟 0 =2 .00 % 𝑟 2 , 𝐻𝐿=5.76 %
𝑟 1 , 𝐿 =3 . 12 %
More specifically how the interest rate will
move to the next period is determined by an 𝑟 2, 𝐿𝐿=2.98 %
interest rate model; and how much interest
rate will move depends on the interest rate
volatility.
A Tri-Nominal Interest Rate Model:
𝑟 2 , 𝐻𝐻
How the interest rate will move
𝑟1, 𝐻 r2,HM to the next period depends on the
interest rate model assumed. A
r2,HL Binomial model assumes that the
interest rate will go up or down
with the same probability, while
𝑟 2 , 𝑀𝐻 a tri-nominal model assumes that
interest rate will have three
𝑟0 r1,M 𝑟 2 , 𝑀𝑀 moves to go to the next period.
𝑟 2 , 𝑀𝐿
𝑟 2 , 𝐿𝐻
𝑟1, 𝐿 𝑟 2 , 𝐿𝑀
𝑟2, 𝐿𝐿
 The first step for demonstrating the binomial valuation method is to
present the benchmark par curve interest rates:
 1. Benchmark bonds are conveniently prices at par so the YTM and the coupon
rate are the same.
 2. From these par rates, we use the bootstrapping methodology to uncover the
underlying spot rates.
 3. From those spot rates bootstrapped to compute one-period forward rates for
each of the period.
 Those forward rates are then integrated into an interest rate model, with
the interest rate volatility taken into account, to derive the potential
future interest rates for a binomial interest rate tree.
Maturity Bond Par One-year One-year Implied Forward Rate
Price Rate Spot Rate
Bootstrappe
d from Par
Rates
1 100 1.00% 1.0000% 1.0000% - Current one-year rate
2 100 1.20% 1.2012% 1.4028% - One-year rate, one year forward
3 100 1.25% 1.2515% 1.3521% - One-year rate, two years forward
4 100 1.40% 1.4045% 1.8647% - One-year rate, three years forward
5 100 1.80% 1.8194% 3.4965% - One-year rate, four years forward
Using each of the three rates (par rate, spot rate, and forward rate) to value an option-free bond will
produce the same bond price, as they contain the same information
 When approach the valuation of bonds with cash flows that are interest
rate dependent, we must explicitly allow interest rates to change. We
accomplish this task by introducing interest rate volatility in generating
an interest rate tree.
 An interest rate tree is simply a visual representation of the possible

values of interest rates based on an interest rate model and an
assumption about interest rate volatility.
Interest-Rate Lattice
 The next chart shows an example of the most basic type of interest-rate lattice or
tree, a binomial interest-rate tree. The corresponding model is referred to as the
binomial model.
 In a binomial model, it is assumed that interest rates can realize one of two possible
rates in the next period.
 Valuation models that assume that interest rates can take on three possible rates in
the next period are called trinomial models.
 More complex models exist that assume that more than three possible rates in the
next period can be realized.
This chart is identical to
Exhibit 5 from the AS
Book on p. 405.
Here r represents the
one-period forward rate
at time t.
N is the value of the bond
at that particular node at
time t.
A Tri-Nominal Interest Rate Model:
𝑟 2 , 𝐻𝐻
𝑟1, 𝐻 r2,HM
r2,HL
𝑟 2 , 𝑀𝐻
𝑟0 r1,M 𝑟 2 , 𝑀𝑀
𝑟 2 , 𝑀𝐿
𝑟 2 , 𝐿𝐻
𝑟1, 𝐿 𝑟 2 , 𝐿𝑀
𝑟2, 𝐿𝐿
 How to obtain the two possible one-year interest rates one year from today (1-year forward rate 1
year from today):
 Two assumptions are required: an interest rate model and a volatility of interest rates.
 An interest rate model puts structure on the randomness, here we use the lognormal random walk,
resulting in a tree structure often referred to as a lognormal tree.
 A lognormal model of interest rates ensures two appealing properties (1) non-negativity of interest
rates and (2) higher volatility at higher interest rates.
 At each node, there are two possible rates one year forward at Time 1. We will assume for the time
being that each has an equal probability of occurring. The two possible rates we will calculate are
going to be higher and lower than the one-year forward rate at Time 1 one year from now.
 The interest rate tree is constructed using a process that is similar to
bootstrapping but requires an iterative procedure to determine the interest
rates that will produce a value for the on-the-run issues equal to their market
value.
 The interest rates shown in the binomial interest rate tree are actually one-
period forward rates (rt,H and rt,L). They are the one-period forward rates
starting in period t. At each node of the tree there are interest rates and thus,
there is a set of forward rates for each year.
 In a binomial model, it is assumed that the random event will take on only
two possible values. Moreover, it is assumed that the probability of realizing
either value is equal.
In the chart, interest rate
could go up or down to the
Next period, r1,H or r1,L.
How r0 moves to r1,H or r1,L.

depends on the interest
rate model assumed. How
big the r1,H or r1,L. will be
depends on the volatility.
NH and NL in the chart are

the bond value at that
particular node given the
projected forward rate.
The binomial
model limits the
number of interest
rate moves, and
therefore simplifies
the projections.
 At node 0, this is the root of the tree and is nothing more than the current one-year rate, (which
is also the one-year forward rate), which is denoted as r 0. In the model, a one-factor interest rate
model is assumed. More specifically, it is assumed that the one-year forward rate can evolve
over time based on a random process called a lognormal random walk with a certain volatility.
 The lognormal random walk posits the following relationship between r H and rL, the rates in the
binomial interest rate tree. The relationship between r1,L and r1,H for year 1 can be represented
by
 r1,H = r1,L (e2σ )
 Where σ is the assumed volatility (standard deviation) of the one-year forward rate and
e=2.7183, the natural logarithm.
 The random possibilities each period are (nearly) centered on the forward rates calculated from
the benchmark curve.
 The intuition of the above relationship: Think of the one-year forward implied interest rate from the yield
curve as the average of possible values for the one-year rate at Time 1. The lower of the two rates, rL, is one
standard deviation below the mean (the implied one-year forward rate) and r H is one standard deviation
above the mean. If assumes that the implied forward rate for t=1 is the same as r 0, then
 r1,H = r0 (eσ )
 And r1,L = r0 (e- )
 Thus, the higher and lower values (rL and rH) are multiples of each other and the multiple is , as the equation
above:
 r1,H = r1,L (e2σ )
 Note that as the standard deviation (volatility) increases, the multiplier increases and the two rates will grow
farther apart but will still be (nearly) centered on the implied forward rate derived from the spot curve.
The lower of the two rates, rL, is one standard deviation below the mean (the implied one-year forward
rate) and rH is one standard deviation above the mean, but still centered on the implied forward rate.
r3,HHH = r3,LLL ( e6σ)
σ
r2,HH = r2,LL (e4σ)
σ
σ
r3,HHL = r3,LLL ( e4σ)
σ
σ σ
𝑟0 r2,HL = r2,LL (e2σ)
-σ -σ
-
𝑟1, 𝐿 σ
-σ
r3,LLH = r3,LLL ( e2σ)
-σ
𝑟 2 , 𝐿𝐿
-σ
r 3 , LLL
 For example, for Time 1:
 (1) If the r1,L is 4.074% and σ is 10% per year, then
 r1,H =4.074%(e2*0.10) = 4.976%
 (2) If the r1,L is 1.194% and σ is 15% per year, then
 r1,H =1.194%(e2*0.15) = 1.612%

 In the second year, there are 3 possible values for the one-year rate: r2,HH , r2,HL, r2,LL, and they are
related by:
 r2,HH = r2,LL (e4σ) and r2,HL = r2,LL (e2σ)
 Where:
 r2,HH = one-year forward rate at time 2 assuming the higher rate at time 1 and the higher rate at
time 2
 r2,LL = one-year forward rate at time 2 assuming the lower rate at time 1 and the lower rate at
time 2
 r2,HL = one-year forward rate at time 2 assuming the higher rate at time 1 and the lower rate at
time 2, or equivalently the lower rate at time 1 and the higher rate at time 2
 In a given period, adjacent possible outcomes in the tree are two standard deviations apart.
 EX: If the r2,LL is 0.980% and σ is 15% per year, then
 r2,HH = 0.980%(e4*0.15) = 1.786% and
 r2,HL = 0.980%(e2*0.15) = 1.323%
 The middle rate will be close to the implied one-year forward rate one
year from now derived from the spot curve, whereas the other two rates
are two standard deviations above and below this value (Recall that the
multiplier for adjacent rates on the tree differs by a multiple of e2σ).
 For Time 3:
 There are four possible values for the one-year forward rate at Time 3.
once again all the forward rates in the tree are multiples of the lowest
possible rates each year:
 r3,HHH = r3,LLL (e6σ),

 r3,HHL = r3,LLL (e4σ), and
 r3,LLH = r3,LLL (e2σ)

3.2 What is Volatility and How Is It Estimated?
 What does the volatility parameter σ in the expression e2σ represents?
 With a simple lognormal distribution, the changes in interest rates are proportional to the
level of the one-period interest rates each period. Volatility is measured relative to the
current level of rates. It can be shown that for a lognormal distribution:
 The standard deviation of the one-year forward rate = r0σ
 Proof: Given that e2σ ≒ 1+2σ, the standard deviation of one-period forward rate is
 (re2σ – r)/2 ≒ (r + 2σr – r)/2 = σr.


3.2 What is Volatility and How Is It Estimated?
 Ex: If σ is 10% and the one-year rate r0 is 4%, then the standard
deviation of the one-year forward rate is 4%*10%=0.4%.
 If the current one-year rate is 2%, then the standard deviation would be
2%*10%=0.2%.
 As a result, interest rate moves are larger when interest rates are high
and are smaller when interest rates are low.
 One of the benefits of a lognormal distribution is that if interest rates

get too close to zero, the absolute change in interest rates becomes
smaller and smaller. Negative interest rates are not possible.
3.2 What is Volatility and How is It Estimated?
 Two methods to estimate volatility:
 1. By estimating the historical volatility: volatility is calculated by using

data from the recent past with the assumption that what has happened
recently is indicative of the future;
 2.By estimating implied volatility: base on observed market prices of

interest rate derivatives
3.3 Determining the Value of a Bond at a Node
 To find the value of the bond at a particular node, we begin by calculating the bond’s
value at the high and low nodes to the right of the node for which we are interested in
obtaining a value.
 The process involves starting from the last (right-most) year in the tree and working
backwards to get the final solution we want, a process is known as backward induction.
 Effectively, at some node, the value at that node will depend on the future cash flows,
which in turn depends on (1) the coupon payment one year from now and (2) the bond’s
value one year from now. The former is known. The bond’s value depends on whether
the rate is the higher or lower rate reported at the two nodes to the right of the node. So,
the cash flow at a node will be either (1) the bond’s value if the 1-year rate is the higher
rate plus the coupon payment, or (2) the bond’s value if the 1-year rate is lower rate plus
the coupon payment.
 To get the bond’s value at a node, we follow the fundamental rule for
valuation: The value is the present value of the expected cash flows.
The appropriate discount rate to use is the one-year forward rate at the
node.
 Now there are two present values in this case: the PV if the one-year rate
is the higher rate and the PV if it is the lower rate. Because they have
equal probability of occurrence, we take the simple average to get the
value of the bond at the node.
 The bond’s value at node NH:
 VH = the bond’s value for the high 1-year rate

 VL = the bond’s value for the low 1-year rate
 C= coupon payment
 Then the cash flow at a node:
 VH + C for the higher 1-year rate

 VL + C for the lower 1-year rate
 The present value of these two cash flows using the 1-year forward rate at the node, r*, is:

 (VH + C)/(1+r*) = present value for the higher 1-year forward rate
 (VL + C)/(1+r*) = present value for the lower 1-year forward rate
 Then the value of the bond at the node is found as follows (at 50% probability each of occurrence):
 Bond Value at a node =

EX 3: Pricing a Bond Using a Binomial Tree (AS, Page 409-410)Using the interest rate tree (forward
rates) below, find the correct price for a three-year, annual-pay bond with a coupon rate of 5%.
𝑟 2, 𝐻𝐻 =8.00 %
𝑟 1 , 𝐻 =5 .00 %
𝑟 0 =2 .00 % 𝑟 2 , 𝐻𝐿=6.00 %
𝑟 1 , 𝐿 =3 .00 %
𝑟 2, 𝐿𝐿=4.00 %
C=5
Cash flows at each node from a 3-year bond: FV = 100
C=5
V2HH =?
C=5 C=5
V1H =? FV = 100
C=5
V=?
V2HL =?
C=5 C=5
V1L =? FV = 100
C=5
V2LL =?
C=5
FV = 100
Exhibit 9: Value at each node from a 3-year bond: C=5
FV = 100
C=5
r2HH = 8%
V2HH = [0.5*105 +
0.5*105]/(1+8%)
C=5 = 97.2222 C=5
r1H = 5%
V1H = [0.5*(97.2222+5) + FV = 100
0.5*(99.0566+5)]/(1+5%)
= 98.2280
C=5
r0 = 2% r2HL = 6%
V = [0.5*(98.2280+5) + V2HL = [0.5*105 +
0.5*(101.9506+5)]/(1+2%)
0.5*105]/(1+6%)
= 103.0287
= 99.0566
C=5
r1L = 3% C=5
V1L = [0.5*[(99.0566+5)+
0.5*(100.9615+5)]/(1+3%) FV = 100
= 101.9506
C=5
r2LL = 4%
V2HL = [0.5*105 +
0.5*105]/(1+4%)
= 100.9615
C=5
FV = 100
 EX 3: Pricing a Bond Using a Binomial Tree (AS, Page 409-410)
 No matter what level interest rates move to at Time 3, the cash flow from a three-year bond at Time 3 will be the
same par plus a final coupon payment. In addition, a coupon payment will be made at Time 2. Consequently, Time 2
values will be:
 0.5 x [(105/1.08 + 105/1.08)] + 5 = 97.2222 + 5 =102.2222
 0.5 x [(105/1.06 + 105/1.06)] + 5 = 99.0566 + 5 =104.0566
 0.5 x [(105/1.04 + 105/1.04)] + 5 = 100.9615 + 5 =105.9615
 Time 1 values will be the average of Time 2 discounted plus the coupon payment:
 0.5 x [(97.2222/1.05 + 99.0566/1.05)] + 5 = 98.2280 + 5 =103.2280
 0.5 x [(99.0566/1.03 + 100.9615/1.03)] + 5 = 101.9506 + 5 =106.9506
 Finally we bring the price back to Time 0. The Time 0 value is the average of the Time 1 values discounted to today:
 0.5 x [(98.2280/1.02 + 101.9506/1.02)] + 5 = 103.0287

3.4 Constructing the Binomial Interest Rate Tree (from AS, page 410-
417)
 The fundamental principal of constructing the tree is that when a tree is used to value an on-the-run
issue for the benchmark, the resulting value should be arbitrage free. That is, the tree should generate
a value for an on-the-run issue equal to its observed market value. Moreover, the interest rate tree
should be consistent with the interest rate volatility assumed.
 The interest rate at the first node (the root) is the one year interest rate for the on-the-run issue. The
tree is grown just the same way that the spot rates were obtained using the bootstrapping method
based on arbitrage arguments.
 The interest rate for year 1 (2 of them, 1-year forward rates for year 1 to 2) are obtained from the
following information:
 1. the coupon rate for the 2-year on-the-run issue
 2. the interest rate volatility assumed
 3. the interest rate at the root of the tree (the current one-year on-the-run issue).
417)
 Given the above information, a guess is then made of the lower rate at node NL, which is r1,L. The upper
rate, r1,H , is determined by the assumed volatility of the 1-year rate (r1,L). The formula for determining
r1,H given r1,H is specified by the interest rate model used, for example, in a log normal distribution of
interest rates:
 r1,H = r1,L (e2σ )
 Using the guessed r1,L and the corresponding r1,H, the 2-year on-the-run issue can be valued.
 If the resulted value computed using the backward induction method is not equal to the market value of
the 2-year on-the-run issue, then the r1,L that was tried is not the rate that should be used in the tree. A
different r1,L should be tried.
 The process continues in an iterative process until a value for r1,L and the corresponding r1,H produce a
value for the 2-year on-the-run issue equal to its market value.
 With r1,H and r1,L for year 1 determined, we can go on to compute r2,LL, r2,HL, and r2,HH for year 2.
3.4 Constructing the Binomial Interest Rate Tree
 Steps for Using the Binomial Interest Rate Tree for Valuing an Option-Free Bond:
 1. Calibrating an interest rate tree from Treasury yields:

 Step 1: Obtain Treasury par yields;
 Step 2: Convert Treasury par yields to become spot rates;
 Step 3: Calculate forward rates implicitly embedded in spot rates. For each time period from t =1 and on, there are
nodes with different forward rates. Those forward rates are related based on the interest rate volatility assumption:
 r1,H = r1,L (e2σ ), r2,HH = r2,LL (e4σ), r2,HL = r2,LL (e2σ), ……
 2. With the interest rate tree calibrated, those forward rates can be used to compute the value of a bond
with a backward induction:
 Bond Value at a node =



3.4 Constructing the Binomial Interest Rate Tree (from AS, page
410-417)
 EX 4: Calibrating a Binomial Tree to Match a Specific Term Structure (from AS, Page 413-417)
 As in Example 2, given the term structure (the Treasury yield curve) of 2.0%, 3.0%, and 4.0% par rates for maturities one, two and three years:

 Step 1: Bootstrap the spot rates from the par rates and compute the forward rates for years 1 to 3:
 Bootstrap the spot rates: S0=2.0%, S1=3.015%, and S2=4.055%.


 Use the spot rates to compute the average forward rates: F 0,1=2.0%, F1,2=4.040%, and F2,3=6.166%:
 Because the two-year spot rate is the geometric average of the one-year forward rate at Time 0 and the one-year forward rate at Time 1, we can infer the average
forward rate for Time 2:
 Using formula: (1+St)t = (1+St-1)t-1
 Implies = 4.040%.
 And (1.04055)3 = (1.03015)2(1+F2,3) implied F2,3 = 6.166%
 Notations here: Yt= YTM of a par bond with t years to maturity;

 St=spot rate for a t-year zero-coupon bond;
 Ft,t+1=one-year forward rate for period from t to t+1.
417)
 Use the spot rates to compute the forward rates: F0=2.0%, F1=4.040%, and
F2=6.166%, assuming interest rate volatility is 15% for all years:
Maturity Par Rate Spot Rate Forward Rate
1 2.0% 2.0% 2.0%
2 3.0% 3.015% 4.040%
3 4.0% 4.055% 6.166%
3.4 Constructing the Binomial Interest Rate Tree (from PPP,
page 384-388)
 Step 2: Calibrating an interest rate tree, assuming that the interest rate
volatility is 15% for all years.
 At Time 0:
 The par, spot, and forward rates are all the same for the first period in a
binomial tree. Consequently,
 Y0=S0=F0=2.0%
page 384-388)
 At Time 1:
 We need to use trial-and-error search to find the two forward rates that produce a value of 100 for
the 3%, two-year bond.
 Second, assume that interest rate changes follow a lognormal distribution, we have
 )
 So the two numbers average to 4.040%, the forward rate on year from today, and one is greater than
the other.
 ) = 4.694%
 Using these two forward rates in pricing, the calculated price is 99.9612, which is not equal to the
market price of the bond, which is 100.
3.4 Constructing the Binomial Interest Rate Tree (from PPP, page
384-388)
Exhibit 18 (page 415) Do the price calculation in a Binomial tree:
U=3.477% and = 4.694%, the resulting price is

not equal to 100
98.3820 (=103/1.04694)
103
0.5
99.9612=[0.5x(98.3820+3)
+0.5x(99.5390+3)]/1.02
0.5 99.5390 (=103/1.03477)

103
page 384-388)
 At Time 1:
 Because these two forward rates do not produce the exact pricing for the bond, an iterative process has to be
used to find the exact forward rates that will price exactly.
 The lower trial rate need to be lower than the implied forward rate of 4.040%, for instance, 3.500%. The
higher trial rate would be 3.500%*(e*0.15) = 4.0664% and the lower rate 3.0125%


 These lead to a Time 0 value for the bond of 100.4721.
 103/1.0406664 = 98.9753 and 103/1.030125 = 99.9879

 [3 + (0.5*98.9753 + 0.5*99.9879)]/(1+2%) = 100.4721
 The price computed, 100.4721, is higher than the par price of 100, and therefore higher rates are to be tried.
384-388)
To start, try =3.0125% and = 4.0664%, the

resulting price is greater than 100
98.9753
(=103/1.040664) 100+3
0.5
100.4721=[0.5x(98.9753+3)
+0.5x(99.9879+3)]/1.02
0.5 99.9879 (=103/1.030125)

100+3
384-388)
 At Time 1:
 Finally, by using numeric methods (a trial & error process via Excel’s Solver), we find that the actual
number for = 3.442% instead of 3.477%, making = 4.646% instead of 4.694%.
 Exhibit 17: Binomial Tree to Calibrate (AS, page 415)
 Time 0 Time 1 Time 2

 4.646%
 2.0%
 3.442%
 These are the correct rates because the value of the bond at Time 0 is 100:
 103/1.04646 = 98.427
 103/1.03442 = 99.573
 [3 + (0.5*98.427 + 0.5*99.573)]/(1+2%) = 100.000
384-388)
98.427 (=103/1.04646)
100+3
0.5
100=[0.5x(98.427+3)+0
.5x(99.573+3)]/1.02
99.573 (=103/1.03442)
0.5 100+3
384-388)
 At Time 2:
 Given the spot rates of S1=2.0%, S2=3.015%, and S3=4.055%, we can compute the average forward
rate for Time 2:
 Using forward Rate Formula:


 (1+St)t = (1+St-1)t-1
 This is the middle forward rate for time 2, the lower and upper forward rates will be:
 (6.616%)() = 4.569% and

 (6.616%)() = 8.325%
384-388)
 Using the above trial forward rates, to compute the price of the 3-year 4% par bond that pays $100 at the end of 3 years, first compute
its discounted value at the end of year 2:
 Value at HH-state = 0.5[104/(1.08325) + 104/(1.08325) = 96.009;

 Value at HL-state = 0.5[104/(1.06617) + 104/(1.06617) = 97.960;
 Value at LL-state = 0.5[104/(1.04569) + 104/(1.04569)] = 99.457.
 Discount these values from year 2 to year 1:
 Value at H-state at the end of year 1

 = 0.5[(96.009+4)/(1.04646) + (97.960+4)/(1.04664) = 96.501; or
 Value at L-state at the end of year 1
 = 0.5[(97.960+4)/(1.03443) + (99.457+4)/(1.03442)] = 99.291
 Price at time 0:
 Value at time 0 = [(0.5)(96.501+4)+(0.5)(99.291+4)]/1.02=99.898
 The value is not equal to 100, new forward rates would have to be tried.
414-417)
 At Time 2:
 Exhibit 20 (page 417): Using numeric methods, we find that the three
correct one-year forwards are 4.482%, 6.050%, and 8.167%:
 Time 0 Time 1 Time 2

 8.167%
 4.646%
 2.00%
2.0% 6.050%
3.442%

4.482%

414-417)
 The calibrated forward rates for time 2 are 8.167%, 6.050%, and 4.482%. These are verified:
 Using the above trial forward rates, to compute the price of the 3-year 4% par bond that pays $100 at the end of 3 years, first
compute its discounted value at the end of year 2:
 Value at HH-state = 0.5[104/(1.08167) + 104/(1.08167) = 96.148;

 Value at HL-state = 0.5[104/(1.06050) + 104/(1.06050) = 98.067;
 Value at LL-state = 0.5[104/(1.04884) + 104/(1.04884)] = 99.538.
 Discount these values from year 2 to year 1:
 Value at H-state at the end of year 1

 = 0.5[(96.148+4)/(1.04646) + (98.067+4)/(1.04664) = 96.618; or
 Value at L-state at the end of year 1
 = 0.5[(98.067+4)/(1.03442) + (99.539+4)/(1.03442)] = 99.382
 Price at time 0:
 Value at time 0 = [(0.5)(96.618+4)+(0.5)(99.382+4)]/1.02 = 100.00

414-417)
Exhibit 20: Pricing a Bond Using a Binomial Tree (AS, Page 414-417)Using the interest rate tree
(forward rates) below, find the correct price for a three-year, annual-pay bond with a coupon rate of
4%.
96.148
(=104/1.08167)
104
96.618 = 8.167%
(=[4+(0.5x96.148+0.5
x98.067)/1.04646
= 4.646% 4 104
100
(=[4+(0.5x96.618+0.5x99.382) 98.067
]/1.02000
4 (=104/1.0605) 104
= 2.000% = 6.050%
99.382
(=[4+(0.5x98.067+0.5 4
x99.539)/1.03442
= 3.442%
99.539 (=104/1.04482)
= 4.482%
104
3.5 Valuing an Option-Free Bond with Tree
 The bond price calculated with an arbitrage-free approach with spot rates and with the
arbitrage-free binomial lattice should be the same.
 Consider an option-free bond with 4 years remaining to maturity and a coupon rate of 2%.
 1. Discounting the cash flows with spot rates:
 The value of this bond can be calculated as:


 + + + = $102.3254
 2. Using a binomial tree for the price of this bond in the following, which is
 102.3254, very close.
Exhibit 21: Value at each node from a 4-year bond: 99.1892=102/1.028338=( 102
0.5*102+0.5*102)/
1.028338
=2.8338%
99.7638 102
=([2+(0.5*99.1892 +
0.5*99.9026]/(1.01786
2
3)
=1.7863%
100.6769 = [2+ 99.9026=102/1.02
(0.5*(99.7638) +
0.5*(100.8360)]/(1.01612 2 994
1)
=1.6121%
=2.0994%
100.8360=
102.3254 = [2+0.5*100.6769
[2+(0.5*99.9026 +
+ 0.5*102.0204)]/(1.0100)
2 0.5*100.4380]/(1.0132
2 102
=1.0000% 23)
=1.3223%
102.0204 =
[2+(0.5*100.8360+ 100.4380=102/1.0
0.5*101.647)]/(1.01 15552 102
943) 2
=1.1943%
=1.5552%
101.647 =
[2+(0.5*100.4380 +
0.5*100.8383]/(1.0098 2
03)
=0.9803%
100.8383=102/1.0115
21 102
=1.1521%
EX 5: Confirming the Arbitrage Free Value of a Bond (AS Book, pp.
418-419)
 Example 5: Using the par yield curve: 2% for a 1-year annual-pay bond, 3% for a
2-year bond, and 4% for a 3-year bond. The interest rate tree will be calibrated as:
𝐹 2, 𝐻𝐻 =8.167%
Note: This
Binomial is
𝐹 1, 𝐻 =4.646 % taken from
Exhibit 20 on
𝑟 0 =2 .00 % 𝐹 2, 𝐻𝐿 =6.051% Page 417.
𝐹 1, 𝐿 =3. 442%
 And the price of the bond is calculated as: 𝐹 2, 𝐿𝐿 =4.482%

Exhibit 23 Valuing a 5% Three-year Bond
97.0721=105/1.0816
7
105
8.167%
98.4663=[5+(0.5x97.07
21+0.5x99.0099)]/
1.04646
5
4.646%
102.8105=[5+(0.5x98.46 99.0099=105/1.06051
63+0.5x101.2672)]/1.02 5
6.051%
105
2.000% 101.2672={5+(0.5
x99.0099+0.5x100
.4958)]/1.03442 5
3.442%
100.4958=105/1.0448
2
105
4.482%

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L6.

 Valuation tools must produce a value that is arbitrage free.

 In well-functioning markets, prices adjust until there are no arbitrage

 (A). The bond price as computed with the DCF approach:

 In the example, one-year spot rate z1 is 2.00%, solve for z2:

 To solve for z3:

 Step 2: The correct arbitrage-free price for the bond is:

 Price paid to buy the bond = 102.7751

 A valuation model involves generating an interest rate tree based on

 The assumed volatility of interest rates incorporates the uncertainty

 An interest rate tree is simply a visual representation of the possible

How r0 moves to r1,H or r1,L.

NH and NL in the chart are

 r1,H = r1,L (e2σ )

 r1,H = r1,L (e2σ )

 (1) If the r1,L is 4.074% and σ is 10% per year, then

 r1,H =4.074%(e2*0.10) = 4.976%

 (2) If the r1,L is 1.194% and σ is 15% per year, then

 r1,H =1.194%(e2*0.15) = 1.612%

 r2,HH = r2,LL (e4σ) and r2,HL = r2,LL (e2σ)

 r3,HHH = r3,LLL (e6σ),

 The standard deviation of the one-year forward rate = r0σ

 (re2σ – r)/2 ≒ (r + 2σr – r)/2 = σr.

 One of the benefits of a lognormal distribution is that if interest rates

 1. By estimating the historical volatility: volatility is calculated by using

 2.By estimating implied volatility: base on observed market prices of

 VH = the bond’s value for the high 1-year rate

 Then the cash flow at a node:

 VH + C for the higher 1-year rate

 Bond Value at a node =

 0.5 x [(98.2280/1.02 + 101.9506/1.02)] + 5 = 103.0287

 r1,H = r1,L (e2σ )

 1. Calibrating an interest rate tree from Treasury yields:

 r1,H = r1,L (e2σ ), r2,HH = r2,LL (e4σ), r2,HL = r2,LL (e2σ), ……

 Bond Value at a node =

 Bootstrap the spot rates: S0=2.0%, S1=3.015%, and S2=4.055%.

 Using formula: (1+St)t = (1+St-1)t-1

 And (1.04055)3 = (1.03015)2(1+F2,3) implied F2,3 = 6.166%

 Notations here: Yt= YTM of a par bond with t years to maturity;

U=3.477% and = 4.694%, the resulting price is

0.5 99.5390 (=103/1.03477)

 These lead to a Time 0 value for the bond of 100.4721.

 103/1.0406664 = 98.9753 and 103/1.030125 = 99.9879

To start, try =3.0125% and = 4.0664%, the

0.5 99.9879 (=103/1.030125)

 Exhibit 17: Binomial Tree to Calibrate (AS, page 415)

 Time 0 Time 1 Time 2

 Using forward Rate Formula:

 (6.616%)() = 4.569% and

 Value at HH-state = 0.5[104/(1.08325) + 104/(1.08325) = 96.009;

 Discount these values from year 2 to year 1:

 Value at H-state at the end of year 1

 Value at time 0 = [(0.5)(96.501+4)+(0.5)(99.291+4)]/1.02=99.898

 Time 0 Time 1 Time 2

 Value at HH-state = 0.5[104/(1.08167) + 104/(1.08167) = 96.148;

 Discount these values from year 2 to year 1:

 Value at H-state at the end of year 1

 Value at time 0 = [(0.5)(96.618+4)+(0.5)(99.382+4)]/1.02 = 100.00