CFA Level 2 | Derivatives: Valuing Interest Rate Options Using Binomial Option Valuation Model

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CFA Level 2
Topic: Derivatives
Reading: Valuation of Contingent Claims

When valuing interest rate options using the binomial option valuation model, the steps are:
1) Calculate the option payoffs at expiration
2) Calculate the weighted payoffs using the risk-neutral probability, then discount it back to the previous period using the previous period's one-period forward rate.
3) Repeat Step 2 all the way back to Time 0 to get the option value per $1 notional
4) Multiply the notional to the option value to scale it and you are done!

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