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I am trying to use a binomial model to price options wtih bonds as the underlying security.If the current term structure is flat at 6%, but next year, I assume the one-year spot rate will be either 5% or 7% with no other possible values. So I calculated the new prices to be either .935 (5% return) or .9524 (7% return). I want to compute the risk neutral probability that the one-year spot rate will drop to 5%. I'm thinking that I can do this by solving for the probability of the expected return of the strategy of purchasing the two-year zero and reselling it in one year is equal to today's spot rate of 6%, but I need some guidance in how to approach this.

  • Do you have a book which you use in your course ? This should be explained, as this one of the basic exercises. Bayes theorem should be helpful in doing this. – DumbCoder Apr 4 at 10:49
  • This might be better-suited for quant.stackexchange.com – 0xFEE1DEAD Apr 4 at 21:48

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