Comment 1: In the valuation process, the interest rate tree generates cash flows that are interest rate dependent but does not provide the interest rates used to discount those cash flows.
Comment 2: Two assumptions must be made to create a binomial tree. The first is an interest rate model such as a lognormal model of interest rates. The second is a volatility of interest rates.
Comment 3: Volatility can be measured relative to the current level of rates. By using a lognormal distribution, interest rate movements are proportional to the level of rates and are bounded at the low end by zero. Q: Which is the incorrect statement. The answer is comment 1 which is fine and I understand that its wrong since the binomial tree is also expected to provide cashflows. but why is 2 correct? there are 3 assumptions needed to create a binomial tree and not 2. 1) assumption regarding the interest rate model then the current benchmark rates and then an assumption about interest rate volatility.