Binomial Trees (for Fixed Income)

Binomial trees are used in a variety of contexts in finance:

• Calculating probabilities for Bayes’ Formula type problems
• Calculating the value of options on stocks, commodities, and so on
• Calculating the option-adjusted spread (OAS) for bonds
• Calculating the value of bonds with embedded options
• Calculating the value of floating-rate bonds
• Calculating the value of interest rate caps and floors

In this series of articles, we’ll be concerned with the application of binomial trees to the valuation of bonds.  For the other applications, click on the links above.  We’ll cover:

• How a binomial interest rate tree is created (Although you’ll never have to do this on the exam, it’s interesting in its own right, and it forestalls the otherwise inevitable question, “Where did they get the numbers in the tree?”)
• How a binomial interest rate tree is used to calculate OAS
• How a binomial interest rate tree is used to value bonds with embedded options
• How a binomial interest rate tree is used to value floating-rate bonds

That’s more than enough.