Use the fact that the pseudo-probability of default at time zero is (1 / 2)to answer the questions that follow.
-Consider a floorlet with maturity time 1 and strike price 0.035.What are the payoffs to the option at time 1 in the up and down nodes?

Question

Use the fact that the pseudo-probability of default at time zero is (1 / 2)to answer the questions that follow. 
-Consider a floorlet with maturity time 1 and strike price 0.035.What are the payoffs to the option at time 1 in the up and down nodes?

Quizplus · Accepted Answer

The payoff of a floorlet is max(strike - interest rate, 0). At the up node, the interest rate is higher than the strike, so the payoff is 0. At the down node, the interest rate is lower, resulting in a positive payoff.

Use the Fact That the Pseudo-Probability of Default at Time