Quick question, when using backward induction to value option-free bonds vs. embedded options, the former does not discount the coupons but the latter does? Is it due to embedded bonds being dependent on cash flow to determine if it is called/put and that option-free do not? Thank you.
I think we discount coupons on option-free bonds too. Where you found example in which we don’t discount them?
Page 309 of CFAI FI book in question 4. The solution shows that the coupon 2.5 is just added after discounting the price.
In node 2-2 and node 2-3 the coupon is already included in the provided numbers so we discount the whole sum at the corresponding rate. Note for example how note 0 is calculated:
0.5 * [105.2917 (in this number you already have 2.5 coupon) + 104.2876] / 1.0125 = 103.496
Coupons are added and discounted for both option free bonds and bonds with embedded options. Same process, only difference is whether you alter the price due to it being called/put or not.
Wait, are we talking about the same problem? #4 in EOC on page 309.
Value = .5 [(104.0168/1.014925 + 104.635/1.014925)] + 2.5
They add 2.5 after discounting??
I think it’s just a weird arithmetic rearrangement. I honeslty ignored a lot of the provided derivations from the CFAI because they end up confusing me. You can treat the way you discount coupons the same (i.e. - Add them before you discount them back)
That’s what I thought. This drove me insane. I thought I was losing it. Thank you!