Question: Suppose at time t = 0 you are given four default-free zero-coupon bond prices, P(t, T), with maturities from 1 to 4 years: P(0, 1)

Suppose at time t = 0 you are given four default-free zero-coupon bond prices, P(t, T), with maturities from 1 to 4 years:
P(0, 1) = 0.94, P(0, 2) = 0.92, P(0, 3) = 0.87,
P(0, 4) = 0.80
(a) How can you "fit" a spot-rate tree to these bond prices? Discuss.
(b) Obtain a tree consistent with the term structure given above.
(c) What are the differences, if any, between the tree approaches in questions (a) and (b)?

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a There are multiple methods to generate such a tree A first method simply finds the forward curve implied by a set of observed market bond prices These implied forward rates may not necessarily be ex... View full answer

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