Determining the value at a node or backward induction, Financial Management

The value of node is determined using a methodology called backward induction. The value at any node depends on the future cash flows; therefore, we need to start from the last year in the tree and work backwards to get the required solution. For example, if we want to find the value at node T, we need to first calculate the value at node TH and TL and to find the value of bond at node TH; also, we need to first calculate the value of the bond at nodes THH and THL which is nothing but the future cash flows. The future cash flows depend on two factors. First, the coupon payment one year from now; and second, the bonds value one year from now. We have already seen that at every node there are two options and the node can take a higher or lower value. Therefore, the cash flow at a node can either be the bond value if the 1-year rate is higher rate plus the coupon payment or the bond value if the 1-year rate is lower rate plus the coupon payments. Coming back to our example, the cash flow at T will either be bond rate at THH plus coupon rate or the bond rate at THL plus coupon payment.

We need to calculate the present value of the expected cash flow to get the bond value at a node. We get two present values in each case, one is the present value if the 1-year rate is higher and the other if it is lower. As we have two options with equal probability, an average of the two present values is computed.

VH     =       Higher 1-year rate value of the bond.

VL       =       Lower 1-year rate of the bond.

P       =       Coupon payment.

r*      =       1-year rate at the node where the valuation is sought.

Therefore, the cash flow at a node is

VH + P for the higher 1-year rate (or)

VL+ P for the lower 1-year rate.

Present value of the cash flows using the 1-year rate at the node, is calculated as follows:

Present value for the higher rate = 256_determining value at node.png

Present value for the lower rate = 2381_determining value at node1.png

The value of the bond at the node is 2234_determining value at node2.png

Posted Date: 9/10/2012 6:47:35 AM | Location : United States







Related Discussions:- Determining the value at a node or backward induction, Assignment Help, Ask Question on Determining the value at a node or backward induction, Get Answer, Expert's Help, Determining the value at a node or backward induction Discussions

Write discussion on Determining the value at a node or backward induction
Your posts are moderated
Related Questions
State about the two types of Government Securities There are two types of Government Securities which are offered: Government Floating Rate Bonds which pay a floating rate

Treasury Bills in International Markets A brief discussion on treasury bills in international markets is given below: Primary Market T-bills are important money market

QUESTION a) Discuss the importance of diversification in the context of stock markets using appropriate numerical illustrations. b) Mimine and Minush are two companies with

Q. Definition of Capital Budgeting? Capital Budgeting is the procedure of making decisions for investment in long-term assets. It is a method of deciding whether or not to inve

Segment Margin This is the amount in which a business segment in a company contributes toward the common or indirect cost of the company. Therefore, it represents that segment'

What are the types of major types of finance companies? There are three main types of finance companies: a. Sales finance institutions which make loans to customers of a cer

Define the term in brief -Called-up share capital Called-up share capital that you may find in some of balance sheets. It refers to that part of subscribed capital, which share

annual uasage of stock 100,000units carrying cost per unit of stock RM2 order cost RM250 question there is a constraint arising from the floor space of the

A simple passive strategy involves building a portfolio and holding it through time. The coupons as well as the proceeds of matured bonds are just reinvested in new iss

The ledger of AISExperts Inc. showed the following balances after adjustment , but before closing, on December 31, 2012, the end of the current year: Accounts payab