Why do they add 4? I thought the dividend was included in the 104? I can’t find any other examples where they do this.
Never mind. I found it in the curriculum.
I really think Schweser and CFAI do backward induction on option free bonds differently.
Do this every time and you can’t go wrong …
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Sketch your tree with boxes where your prices are going to go
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Find your coupon, multiply it by 2 then store it in your calculator
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Then hit these keystrokes: Node (up) + Node (down) + Recall (memory spot for 2x coupon) divided by 2.
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Divide the result of #3 by 1+ the interest rate in the t-1 Node down the tree, write the result in the box for that Node (see # 5 for callable/putable bonds)
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Is it a bond with an embedded option? If callable and the price you calculated is above 100, write 100 in your box (assuming 100 is the call price). If not above 100, write in the calculated amount. If putable and the price is below 100, write 100 in your box (again assuming 100 is the put price). If not below 100, write in the calculated amount. If it’s a straight bond simply write the calculated amount in your box.
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Rinse and repeat steps #3 to #5 on down the tree
Doing this will make sure you evaluate whether a bond with embedded options is called or put correctly, and will get you to the correct valuation every time unless you fat fingered a number somewhere. Also be sure to read carefully to determine the call/put rules (after 1 year, only in year 3, immediately, etc.).