The Arbitrage-Free Valuation Framework

Question 1

Interest rate tree is a visual representation of possible values f interest rates and it is based on

Answer 1

An interest rate model and an assumption about interest rate volatility

Question 2

What is stripping?

Answer 2

A dealers ability to seperate the bonds individual cash flow and trade them as zero-coupon bonds securities.

Question 3

What is reconstitution

Answer 3

a dealer can recombine the appropirate individual zero-coupon securities and repoduce the underlying coupon treasury

Question 4

2 methods used to estimate potential interest rate volatility in a binomial model is …

Answer 4

1. Based on estimate on historical interest rate volatility
2. Use observed market prices of interest rate derivatives