- CFA Exams
- CFA Level I Exam
- Topic 6. Fixed Income
- Learning Module 29. The Arbitrage-Free Valuation Framework
- Subject 2. The Basics of Creating a Binomial Interest Rate Tree
CFA Practice Question
In the binomial interest rate tree, if i1, H is 6%, and the assumed volatility of the one year rate is 15%, i1, H is above the implied forward rate by:
A. 0.78%
B. 0.90%
C. 0.45%
Explanation: i1, L = i1, H/e2σ = 4.4444%. The distance between the two rates is 6% - 4.4445% = 1.556%. Half of the distance is 0.778%.
User Contributed Comments 2
| User | Comment |
|---|---|
| Lt2201 | Their answer is wrong (takes the difference and halves it, rather than using exponentials to work back to the forward rate). The right method should be: 0.06*exp(-0.15) = 5.164% = 1 year forward rate Thus 6% is above the forward rate by 0.836%. |
| jyoti | The answer is correct. You take the average of the two adjacent higher and lower rate. The textbook says "The middle rate will be close to the implied one-year forward rate one year from now derived from the spot curve, whereas the other two rates are two standard deviations above and below this value." |