‘The fundamental principle is that when a tree is used to value an on-the-run issue for a benchmark, the resulting value should be arbitrage free. That is, the tree should generate a value for an on-the-run issue equal to its observed market value.’ (v5,279) why am i bothering to calculate if i assume from the beginning that the construction of the binomial tree is arbitrage free?

i dont know who you are barthezz, but I think you may be on the wrong forum. This is a forum for Level Two Chartered Financial Analyst Charterholders Candidates. we dont talk about trees or plants. you might be looking for another botanical forum elsewhere.

think of it this way: all the spread measures use treasury as a bench mark, and OAS is the spread you need to add to every paths of interest rate tree. if the result from interest rate tree on treasury is not arbitrage free, the spread measures won’t be accurate either

dkitty, so i generate the tree using an on-the-run, option free benchmark, given market value, volatility and end-price of the treasury bond. after doing so i use the exact same tree to calculate the price of an callable bond or use the same tree to add the OAS to each node. correct?

you construct the tree using arbitrage free value of treasury, then you use the tree you just constructed, and OAS to each node for callable/putable if u use the tree without adjusting for OAS, the value of callable and putable will be biased.

got it. thanks for the explanation!

nobody has a sense of humor these days…