Assume a binomial process for changes in the risk-free rate, with annual movements of u = 1.3 and d = .7. This period rate is 8% and has just moved down from 11.4286%.
What is the market value of a three-year variable rate loan where the variable rate is set as the arithmetic average of this period rate and last period rate?
How would your answer change if the interest rate had just moved up from 6.1538% instead of down?