Hi everyone, When they give us an interest rate tree, we are asked to compute the value of the bond at each node with the interest rate they give us… However, i really feel that they use interest rate instead of the YTM… For example : FRA 2x3 = 8.56% with a 7% coupon bond maturing in the third year. For them the value of the bond in year 2 is : N=1; I/Y=8.56 ; PMT=7; FV=100; CPT~ PV= 98,56 What about a bond with a very high YTM because of credit risk ? the price would be much lower… any idea ?
The interest rate tree uses forward rated because each rate discounts _ a single value _ from one point in time to the time one period earlier.
YTM is used to discount _ all values _ (cash flows) to today.
Thanks for your help even if i am still not very sure of me on this… I got to the conclusion that the bond we are suppposed to price is credit risk free, so it makes sense to discount it with the interest rate tree… or the interest rate tree we are given is extracted from a “credit curve” to adapt for the credit quality of the bond… I remembered that a credit spread could be added to interest tree to get the correct pricing so it must be somethng like that.