I’ve run into several questions that give you a binomial tree of interest rates and asks to calculate the interest rate call option value and provides a notion amount.
Let’s assume a 5% strike with a notion of $2M two year euro call option. The binomial tree is
4% 5.31% 8.3%
3.22% 5.04%
3.06%
So option strike hits at 8.3% and 5.04% with values of $66K and $800. Then I start working it through the tree. However, in the past I’ve had to discount these values by 8.3% and 5.04% respectively… However, this problem I ran into skipped those nodes and discounted it by T1 interest rates (5.31/3.22/3.06) rather than starting at T2 interest rates. So it seems inconsistent.
Q :Is the reason because the problem has to state “payments are made in arrears” to start discounting at T2 rather than T1?