Question #17
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 8
Status: Correct
Correct Answer: A
Question
Sam Roit, CFA, has collected the following information on the par rate curve, spot rates, and forward rates to generate a binomial interest rate tree consistent with this data. Maturity Par Rate Spot Rate 1 5% 5.000% 2 6% 6.030% 3 7% 7.097% The binomial tree generated is shown below (one year forward rates) assuming a volatility level of 10%: 0 1 2 5% 7.7099% C A 9.2625% B Roit also generated another tree using the same spot rates but this time assuming a volatility level of 20% as shown below: 0 1 2 5% 8.9480% 13.8180% 5.9980% 9.2625% 6.2088% The one-year forward rate represented by 'B' is closest to:
Answer Choices:
A. 8.7732%
B. 7.5835%
C. 7.4223%
Explanation
Value represented by 'B' = 9.2625 / e2x0.10 = 7.5835%