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Answer: the binomial interest rate tree is not properly calibrated to the spot curve.
**Correct Answer: B** When a binomial interest rate tree is properly calibrated to the spot curve, it should produce the same price for an option-free bond as discounting with spot rates. If the tree is not properly calibrated, the two methods will yield different prices. **Why other options are incorrect:** - **A**: If interest rate volatility is assumed to be zero, the binomial tree would collapse to a single path, and both methods should give the same result. - **C**: Using an insufficient number of paths might affect the accuracy of Monte Carlo simulations, but binomial trees are discrete models with a fixed number of paths determined by the number of time steps.
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The value of an option-free bond obtained when discounting cash flows with spot rates will most likely differ from the value obtained by using a binomial interest rate tree when:
A
interest rate volatility is assumed to be zero.
B
the binomial interest rate tree is not properly calibrated to the spot curve.
C
interest rates are simulated using an insufficient number of potential paths.