Hi guys, I will be studying for the CFA for the next weeks and have to start my forum activity with a question. I am looking at the moment at CFA Programm Curriculum Volume 6 (Derivatives and Porfolio Managment), page 179 - Exhibit 19 - Binomial Interest Rate Tree. Maybe it is too late for me today, but I do not get how they come up with the numbers in brackets, i.e. 0,8106 at time 0! Can somedody help me with that one? Thanks in advance, D
they use backwardation, you know what the cash flows are going to be at maturity. the tree already has interest rates at each node. As you go back step by step back in time, you calculate the value at each node (such as .8106) as discounted average of cash flows (value + coupon) of the nodes that are connected to the node. For example, if initial node is n00 (with known annual interest rate r0), and two next nodes (values in one year)are n11 (with value CF11 and annual coupon C) and n22 (with value CF12 and annual coupon C), then CF0 = ((CF11 + C + CF12+C)/2)/(1+r) I hope that helps.
Yes, thanks a lot! D
So just to get a clean chit on this one – what maratikus was referring to was Backward Induction (and not backwardation) .
Yes, it’s quite easy to understand and I figured this would be an ideal topic for CFA to ask on the exam.