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Answer: The interest rate tree is fit to the current yield curve so that the model produces the benchmark bond values
## Explanation The correct answer is **C** because: - **Option A is incorrect**: Binomial interest rate trees typically use lognormal distribution assumptions rather than normal distribution to ensure interest rates remain positive. - **Option B is incorrect**: For option-free bonds, volatility assumptions do not affect the valuation since there are no embedded options whose value depends on volatility. The binomial tree calibration ensures the model reproduces the current term structure regardless of volatility assumptions for option-free bonds. - **Option C is correct**: The calibration process involves fitting the binomial interest rate tree to the current yield curve so that the model produces the same values as the benchmark bonds. This ensures the model is arbitrage-free and consistent with observed market prices. **Key Concept**: Calibration ensures the binomial tree reproduces current market prices of benchmark bonds, making it arbitrage-free.
Author: LeetQuiz Editorial Team
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Which of the following statements regarding the calibration of a binomial interest rate tree to the term structure is most accurate?
A
The interest rate model used in the process is based on the normal distribution
B
The volatility assumption used in the binomial tree impacts the valuation of an option-free bond
C
The interest rate tree is fit to the current yield curve so that the model produces the benchmark bond values
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