- 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.
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