Given a variability of = hVAe = .10 and current one-, two-, and three-period spot rates of y1 = .07, y2 = .0804,

Given a variability of σ =



hVAe

= .10 and current one-, two-, and three-period spot rates of y1 = .07, y2 = .0804, and y3 = .0904952:

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

(Hint: try Sd = .08148 from Problem 10 and Sdd = .0906).

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

c. Does the binomial tree price the 10.5% option-free bond equal to the bond’s equilibrium price?

d. Using the calibrated tree, calculate the value of a three-period, 10.5% bond (F = 100) callable at CP = 101 in periods 1 and 2.

e. Based on the option-free and callable bond values you determined in 12.b and 12.d, estimate the option-adjusted spread.