Suppose that there is a 3-year bond. The binomial tree model generates an “inverted tree” with 1-node at the far left, 2 in the middle, and 3 at the far right. At the far right, the interest rate that is written in the box is the rates of today’s 3-years bond. The price is $100 at t=3. At t=2, the upper node and the lower node both have a different interest rate on it. the upper node has a higher rate and a lower price. I UNDERSTAND HOW TO CALCULATE THIS PRICE. IT’S SIMPLY NEXT YEAR’S CASH FLOW DIVIDED BY THIS NODE’S INTEREST RATE. However, given that there is a 10% volatility, how do you calculate the interest rates in these nodes at t=2.
Try reading this: http://www.bus.lsu.edu/academics/finance/faculty/dchance/Instructional/TN97-14.pdf and see if you get it. Otherwise, I can help with that. It’s tough for me to help with readings I don’t get.
Guys, I’ve found out the answer. The answer is: YOU ARE *NOT* EXPECTED TO CALCULATE THE RATES! THIS WILL ALWAYS BE PROVIDED!