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?
I’ve never seen six possible outcomes in three years.
Can you cite an example?
now looking at this from EOC reeading 46, there are only three outcomes, why there is only three while the interest one binominal tree has four
I mean why is this binominal tree build this way while the interest rate binominal tree is built differently
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/