MATCHING THE MODEL TO THE MARKET
CHAPTER 7 STATED that the expected value of the short rates in a given period must provide the same return as the implied forward rate for that period. Although this condition seemed logical and helped estimate the short rates that appeared in the binomial tree, it provides only a first approximation of their values. In reality, it is far more important for the binomial tree to generate a model-predicted price for a benchmark bond that matches its observed price in the market. This requirement is perhaps the most crucial—and delicate—aspect of constructing such a model.
To test the suitability of the short rates calculated in Chapter 7, the binomial tree will be used to generate a model-predicted price ...