Question #21
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 10
Status: Correct
Correct Answer: A
Question
Tim Brospack is generating a binomial interest rate tree assuming a volatility of 15%. Current 1-year spot rate is 5%. The 1-year forward rate in the second year is either a low estimate of 5.250% or a high estimate of 7.087%. The middle 1-year forward rate in year three is estimated at 6.25%. The upper node 1-year forward rate in year three is closest to:
Answer Choices:
A. 7.747%
B. 6.445%
C. 8.437%
Explanation
Upper node interest rate = 6.25 × e2×0.15 = 8.437%