Trading with Two-Factor Models: Tree Implementation, OAS, and P&L Attribution

Understanding the G2++ bond price formula analytically is one thing; using the model for daily trading decisions is another. This lesson covers the mechanics of turning a two-factor model into a pricing and hedging machine: (1) constructing a two-dimensional binomial tree whose transition probabilities embed the factor correlation, (2) computing the option-adjusted spread for callable bonds in a two-factor environment, (3) defining two-factor DV01s and the P&L attribution that makes a two-factor model operationally distinguishable from two separate one-factor models, and (4) understanding why the 2s-5s-10s butterfly swap position is the canonical two-factor trade — the one that is risk-free in a one-factor world but risky in a two-factor world.