FI - Reading #50 - Binomial Trees

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rjmac

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Are we expected to derive rates on the binomial trees? I’m pulling out my hair trying to figure out how these rates are derived.
 
As far as I know, there is no need to figure out the rates, the LOS just states to calculate the value of a bond from an interest rate tree (meaning rates are given). I’ve done the problems in the EOC CFAI curriculum and not one asks to calculate the rates. However, you can use bootstrapping method to calculate rates which is mentioned in the curriculum.
 
Interest rates will be provided, like swt326 said value of the bond needs to be calculated. Using binomial tree for bonds with embedded option is tricky and likely to be tested through this topic not figuring out the rates.
 
you may be asked to calculate the lower or upper rate given interest rate volitility.
Upper rate = Lower rate x e^(2σ)
 
Yes I agree. If interest rate volatility is given and upper rate or lower rate is given then using this formula you may be asked to calculate the missing rate.
 
Side question: how does one go about determining the rates for non treasury bonds? That is, how exactly does one determine the appropriate spread to use over treasuries when building a tree in the first place ?
I understand how you bootstrap treasury spot rates, but what about nontreasuries?
 
I dont exactly know about it but what if we add a premium over treasury spot rates to come up with an interest rate used in the tree like we do getting a yield of a corporate bond by adding risk premiums to risk free rate? Whats your take onto it?
 
I think i agree with what you’re saying, but what i don’t understand is how you come up with that initial premium (over the treasury) in the first place.
I think it would be helpful to hear from any practicing fixed income analysts…how do you truly value non-treasuries in the “real world” ? I always understood the non-theorectically correct way of using current YTM (or a benchmark YTM assuming the bonds you’re valuing aren’t listed) to revalue a bond, but the theroretically correct way, per CFAI, suggests using spot rates. I understand why this is the more correct method, but how do you do it in practice, for non-treasuries that is ??
 
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