Question #33
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 15
Status: Correct
Correct Answer: A
Question
Suppose that we calculate the value of an option-free, fixed-rate coupon bond, discounting the cash flows using two methods: I. the zero-coupon yield curve. II. an arbitrage-free binomial lattice. Compared to the first methodology, the second method is expected to produce:
Answer Choices:
A. the same value
B. a lower value if the bond carries a coupon higher than the corresponding benchmark bond
C. a higher value in the presence of volatility
Explanation
Because these two valuation methods are arbitrage-free, the two values obtained must be
the same. An option-free bond that is valued by discounting by the spot rates should have
the same value as if the binomial interest rate tree was used.