hi all, quick question, i see when we are doing interest binominal tree, we get 4 outcomes on the third year out of three interest possibilities, why in float cap or floor questions you get six out of three rate possibilities?
There are, in fact, only four nodes: uud and udu are the same, udd and ddu are the same.
What they’re trying to illustrate is that the cash flow will depend on the route you take to get to that node, because the floating rate is determined in advance (but paid in arrears).
Note the middle node at time 2: ud or du. It’s only one node, but they have two possible cash flows, depending on whether the previous node were u or d. To be consistent in their notation, they should have combined uud and udu, and they should have combined udd and ddu.
I haven’t finished my article on caps and floors, but you can see the same sort of thing in my article on floating-rate bonds: http://financialexamhelp123.com/valuing-floating-rate-bonds/
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