UP TO NOW, the focus has been on the construction and calibration of the binomial tree of risk-free short rates. With these tasks completed, the next step is to employ the model to evaluate the return of a bond. This chapter examines the simple case of a nonbenchmark bullet bond and develops the notion of spread within the context of the binomial tree. In Chapter 10, the inquiry will extend to the more complex case of a bond containing an embedded option.
The binomial model evaluates the return of a bond by measuring the extent to which its return exceeds the returns described by the risk-free short rates in the tree. The difference between these returns is expressed as a spread and is viewed as the incremental return ...