 # Valuing bonds with embedded options- help needed

Hi. I’m struggling to get through volume 5. The reading is 54, page 315, Exhibit 12- it’s explained how to calculate value for V+ and V-. I don’t understand where these interest rates come from in Exhibit 12. I look at Exhibit 11 where is the same case with OAS, but without shift in the yield curve. Now we shift the yield curve with 25 b.p. and how do we get 9.8946% in year 3 for Nhhh, when we have 9.5487% for the same thing in Exhibit 11. The difference is not 25 b.p.? What do I miss? Help please.

i dont the book but what i can recal in general (if i can remember well) is that you are likely going to find the interest rates already provided on the tree and your forcus should be on whether there is a call or put option and if there is one the value that you will use will be the exercise price and not if the calculated value is above the strike price for call and below the strike price for puts. try to divided both values ahead in the tree by the interest rate before the values (not the rate in the same box as the value) and multiply by half for both when V+ and when V- and add the two figures to find the value for the box behind. just remember that to use strike value where applicable.

You don’t need to worry about why the number is 9.8946% since you will be given the new tree in the exam. You need to read the procedure given in previous page carefully if you want to understand how to get the new tree, specifically step 2 and 3. You need to recalculate a new interest tree (step2) based on a new YIELD curve which is the old yield curve (which is given previously in REVIEW OF HOW TO VALUE AN OPTION FREE BOND section in CFAi text) + .25% parallel shift. E.g., YTM 3 year bond would be 4.7% +.25%= 4.95%,… Assumed volatility is still 10%. I described the methodology of calculating interest tree briefly in previous posting. http://www.analystforum.com/phorums/read.php?12,1102261,1102333#msg-1102333 year 3 for Nhhh node in the new tree would be 9.5446%, then you add OAS spread of .35% to ALL NODES in the new tree (STEP 3 in the procedure) --> 9.8946% in year 3 for Nhhh

Thanks a lot. So I’m not supposed to find myself the rates in the nodes, but if I am supposed to do this, the bottom one is found by try and error and the upper ones are received by the formula lower node*exp(2*volatility). Its pretty clear now. Thanks again.