 # How to build a binomial tree model for bond valuation?

see the topic. didn’t get any answer in level 2 area, hope i can get something here. I got several questions here, 1. in the book, CFA metioned a binomial tree model need be build before value a bond, ie, interest rate has 60% chance going up and 40% chance going down… my question here is how to predict the percentage? 2.after getting the percentage, which forward rate should be employeed as the benchmark rate? 3. for a specific bond, we shouldn’t just use the benchmark rate. Some spread should be added in, how to value the spread is my third question? I hope I can get some advise here, I have Bloomberg access, so if you find any clue in Bllomberg, it will be perfect! Thanks

Sounds like you need to study for level 2

you are right, i didnt pass it. you know the theory and the real world is different

Don’t post the same thing in two forums.

how to delete my old one in level 2 area?

If I recall correctly, in the L2 curriculum you always assume a 50% probability of going up or down for a BOND. For a STOCK, the probability of an up move is something like: (1 - R(f) - D) -------------- ( U - D) Where R(f) = the risk free rate D = the percentage drop in a down move U = the percentage rise in an up move

Yeah, agreed it did say to always assume 50/50 probability. Although I’m guessing this is more for simplicty sake. Could you use a market indicator showing what % is betting rates go up vs. down? Dwight Wrote: ------------------------------------------------------- > If I recall correctly, in the L2 curriculum you > always assume a 50% probability of going up or > down for a BOND. > > For a STOCK, the probability of an up move is > something like: > > (1 - R(f) - D) > -------------- > ( U - D) > > Where R(f) = the risk free rate > D = the percentage drop in a down move > U = the percentage rise in an up move

artvandalay Wrote: ------------------------------------------------------- > Yeah, agreed it did say to always assume 50/50 > probability. Although I’m guessing this is more > for simplicty sake. > > Could you use a market indicator showing what % is > betting rates go up vs. down? > > > maybe. talk to Renassiance Tech and ask them. but what kind of CI do you need to put money on it.

No. the probabilities you use are risk-neutral probabilities. You have to calibrate to observed market prices. You will not need to know this for CFA. Don’t drill too deeply or you will get lost. if you still want to know, see this http://mathsa.ucd.ie/courses/mst3024/section3-3.pdf