Why is the slution showing the coupons without the disounting?
Shouldn’t these coupons be discounted backwards?
The value at node 1-2 is the present value of the average of the values at nodes 2-2 and 2-3, plus the coupon payment you’ll receive at time 1. As the coupon is received at time 1, it doesn’t require discounting.
This is where the confusion is.
The terminology itself seems to be confusing at times.
In the Wiley Guide they exclude the coupon for that year while calculating the value at that particular node.
Does this mean we have to include coupons for that year regardless of whether or not it is explicitly mentioned in the question?
It means that you have to understand the dynamics of calculating the value at a given node.
- You discount the average of the subsequent two nodes to get the present value of the future cash flows (PV(FCF)). This is the value that you will use to determine whether or not an option would be exercised.
- You add the cash flow to the PV(FCF) to get the value at the node. This is the value that you’ll be discounting to get the value at the preceding node.