Given a variability of = hVAe = .10 and current one- and two-period spot rates

Given a variability of σ =



hVAe

= .10 and current one- and two-period spot rates of y1 = .07 and y2 = .0804:

a. Generate a one-period binomial interest rate tree using the calibration model.

(Hint: try Sd = .08148).

b. What do the values of the upper and lower spot rates relative to the current spot rate of 7% tell you about the structure of interest rates?

c. Using the calibrated tree, determine the equilibrium price of a two-period, option-free, 10.5% coupon bond (F = 100).

d. Does the binomial tree price the 10.5% option-free bond equal to the bond’s equilibrium price? Comment on this feature of the calibration model.

e. Using the tree, calculate the value of a two-period, 10.5% bond (F = 100)

callable in period 1 at CP = 101.