Option-Implied Probabilities and Bond Valuation

Traditional short-rate lattice models assume that interest rates move up or down with equal risk-neutral probability. This symmetry is a convenient modeling device, but it does not reflect how markets actually price risk. We recover contract-level risk-neutral probabilities using option data and find persistent and systematic departures from the 50/50 benchmark. These option-implied asymmetries vary across maturities and market conditions, particularly during volatile episodes such as the onset of the COVID-19 crisis. Embedding the recovered probabilities into bond valuation reveals significant consequences for practitioners. Symmetric models consistently misprice bonds by several basis points, bias expected holding-period returns, and generate hedge ratios that lead to larger tracking errors, higher turnover, and greater transaction costs. Models disciplined by option-implied probabilities produce bond valuations more consistent with market prices, return forecasts that better capture term premiums, and hedges that perform more effectively. The results demonstrate that the symmetry assumption underlying standard short-rate trees is empirically false and economically costly to ignore.