The Binomial Tree of Short-Term Interest Rates

The Binomial Tree of Short-Term Interest Rates 

Chapter 3 discussed how a coupon-hond yield curve could be used to derive spot (zero-coupon) and implied forward rates. A forward rate is the interest rate for a term beginning at a future date and maturing one period later. Forward rates form the basis of binomial interest rate trees. 

Any models using implied forward rates to generate future prices for options underlying bonds would be assuming that the future interest rates implied by the current yield curve will actually occur. An analysis built on this assumption would, like yield-to-worst analysis, be inaccurate, because the yield curve does not remain static and neither do the rates implied by it therefore future rates can never be known with certainty. To avoid this inaccuracy, a binomial tree model assumes that interest rates fluctuate over time. These models 

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