Interest Rate Volatility

[koba]

Level II, Vol 5, page 361, exhibit 5: Can anyone, please, explain to me how the 10% volatility (and the 20% volatility in other examples) was used to derive the interest rates on the binomial interest rate tree? Or are the interest rates on the tree given and thus their derivation is not required or needed? What exactly am I missing, please?

 

[MarcusAntoninus]

Ran into a similar headache in that reading today. Not a real clear explanation in the text for how you find the higher node rates with a given volatility.
Here is the interest rate tree I believe you are looking at.
Basically you calculate up from the lowest node at each time interval.
Here is the same tree with only the bottom nodes filled and the formulas used to calculate higher nodes.
I think the exam could give you a tree with the bottom nodes at each period (L, LL, LLL, etc), and then you will be able to calculate the other rates when they give you a specific volatility measure.
Hope this help!