Similar to the applications of the interest rate tree discussed in fixed income, a variation of the binomial option pricing model as presented can be used for options on bonds and interest rates.
The analyst will need to:
Create an interest rate tree of future spot rates.
Calibrate the interest rate tree so current prices for recently issued bonds are correctly priced.
Value the underlying bond with the calibrated interest rate tree.
Apply the decision rule for the option on each tree node; the value of the option at each node will be its intrinsic value.
Calculate the option's "fair" price by discounting the intrinsic option values through the tree.
