Can someone provide some intuition behind the one-year forward rates used in the binomial interest rate tree for valuing capped/floored floaters? Where exactly do those rates come from? The LIBOR swap curve or the LIBOR spot curve?
If it is the LIBOR swap curve, are we finding the one year forward swap rates (is this even a thing?) to use in the tree? Sorry if it is a naive question. Thanks for any help!
Intuition, or understanding?
You start with a (typically, risk-free) par curve. It could be a government par curve (e.g., the US Treasury par curve), or it could be a LIBOR par curve, or a LIBOR swap curve. It doesn’t really matter, as the technique for constructing the tree does not depend on the source of the par rates. Whatever the source, you choose an interest rate volatility for the tree, then calibrate it so that it prices par bonds correctly.
Note, by the way, that you’ll use the same tree whether you’re valuing option-free, fixed-coupon bonds, callable fixed-coupon bonds, putable fixed-coupon bonds, option-free floating-rate bonds, capped floating-rate bonds, or floored floating-rate bonds. Furthermore, they’ll give you the tree, so all you have to do is use the silly thing.