## Bonds

Finance Junkie
Posts: 99
Joined: Sat Apr 07, 2012 10:24 am

### Bonds

Pls explain:

Qn. Assume that a binomial interest-rate tree indicates a 6-month period spot rate of 2.5%, and the price of the bond if rates decline is \$98.45, and if rates increase is \$96, The risk neutral probabilities respectively associated with a decline and increase in rates if the market price of the bond is \$97 correspond to:
a. 0.1/0.9
b. 0.9/0.1
c. 0.2/0.8
d. 0.8/0.2

Source of qn: Schweser Mock Test

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content.pristine
Finance Junkie
Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

### Re: Bonds

Hi Suresh,

You need to use Binomial Pricing Model to answer this question.
P0 = 97. Now P0 can either move to P1+=98.45 or P1-=96.
Let U, the Up-movement per period = 98.45/97 = 1.0149
Let D, the Down-movement per period = 96/97 = 0.9897
(If down-movement is not given, take is as D=1/U)

The risk neutral probability for an up-movement = (1+Rf-D)/(U-D)
Take Rf = 2.5%/2 = 1.25%
You would get the prob of an up-movement = 0.9
Then, the prob for a down-movement = 1-0.9 = 0.1

Hope this helps.. I didn't know you guys have the Binomial Pricing Model for FRM-I. Is this the current year's mock paper?

Hope this helps..

Finance Junkie
Posts: 99
Joined: Sat Apr 07, 2012 10:24 am

### Re: Bonds

Thanks.

Calculating the up and down movement was not clicking.

And yes the binomial pricing model is in part 1. And teh qn was from thsi yr mock test only.

Anyways Thanks.