Reading 35 - 3.4 Constructing the Binomial Interest Rate Tree - what to know?

CFA Level II Fixed Income
#1

What do we really need to know from this section?

The LOS reads “describe the process of calibrating a binomial interest rate tree to match a specific term structure”, but this section gets quite detailed mathematically. I don’t want to spend too much time on calculations that will not be tested. My main takeway is that, through iterative calculations, one can fit the interest rate tree to the current yield curve of a benchmark bond assuming a certain interest rate volatility.

Does anyone have a summary of the key takeaways that we should know?

#2

You should know how to get an interest rate of a specific node using another from same node, remember that the distance is 2 standard deviations, you should also know that the mid point is a proxy for a one year forward rate. Also calculate the price of a bond based on that interest rate tree using up move factor and down move factor, and calculate the implicit probability of a up and down movements based on that factors. I would practice how to get the interest rates and how to calculate the price of the bond at each node from the tree

#3

You need to know that it’s iterative:

  • You have to determine the (two) 1-period forward rates starting at time t = 1 so that a 2-period par bond is priced correctly
  • Then you have to determine the (three) 1-period forward rates starting at time t = 2 so that a 3-period par bond is priced correctly
  • Then you have to determine the (four) 1-period forward rates starting at time t = 3 so that a 4-period par bond is priced correctly
  • And so on
#4

Thanks, Julio and S2000!

#5

It’s better explained in the FI study session. I would recommend watching MM videos.

#6

My pleasure.