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Answer: the binomial tree is calibrated to the zero-coupon yield curve.
**Correct Answer: C** An arbitrage-free binomial lattice is calibrated to match the current zero-coupon yield curve. This calibration ensures that the binomial tree produces the same prices for zero-coupon bonds as the spot rate curve. Therefore, when pricing an option-free bond using either method, the resulting price should be identical. **Why other options are incorrect:** - **A**: Both methods do not use the bond coupon as the discount rate. The zero-coupon yield curve uses spot rates, and the binomial tree uses forward rates derived from the spot curve. - **B**: Interest rate volatility is applied in the binomial lattice but not in the zero-coupon yield curve method. The zero-coupon yield curve method assumes no volatility.
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Pricing an option-free bond using either an arbitrage-free binomial lattice or the zero-coupon yield curve will result in the same price because:
A
both methods use the bond coupon as the discount rate.
B
the application of interest rate volatility is the same for both.
C
the binomial tree is calibrated to the zero-coupon yield curve.