Determining the value at a node or backward induction, Financial Management

Assignment Help:

The value of node is determined using a methodology called backward induction. The value at any node depends on the future cash flows; therefore, we need to start from the last year in the tree and work backwards to get the required solution. For example, if we want to find the value at node T, we need to first calculate the value at node TH and TL and to find the value of bond at node TH; also, we need to first calculate the value of the bond at nodes THH and THL which is nothing but the future cash flows. The future cash flows depend on two factors. First, the coupon payment one year from now; and second, the bonds value one year from now. We have already seen that at every node there are two options and the node can take a higher or lower value. Therefore, the cash flow at a node can either be the bond value if the 1-year rate is higher rate plus the coupon payment or the bond value if the 1-year rate is lower rate plus the coupon payments. Coming back to our example, the cash flow at T will either be bond rate at THH plus coupon rate or the bond rate at THL plus coupon payment.

We need to calculate the present value of the expected cash flow to get the bond value at a node. We get two present values in each case, one is the present value if the 1-year rate is higher and the other if it is lower. As we have two options with equal probability, an average of the two present values is computed.

VH     =       Higher 1-year rate value of the bond.

VL       =       Lower 1-year rate of the bond.

P       =       Coupon payment.

r*      =       1-year rate at the node where the valuation is sought.

Therefore, the cash flow at a node is

VH + P for the higher 1-year rate (or)

VL+ P for the lower 1-year rate.

Present value of the cash flows using the 1-year rate at the node, is calculated as follows:

Present value for the higher rate = 256_determining value at node.png

Present value for the lower rate = 2381_determining value at node1.png

The value of the bond at the node is 2234_determining value at node2.png


Related Discussions:- Determining the value at a node or backward induction

What are the market conditions of cost of capital, What are the Market cond...

What are the Market conditions of cost of capital Security may not be readily marketable when investor wants to sell; or even if a continuous demand for security does exist, p

Different cost of capital with changed proportions, Different Cost of Capit...

Different Cost of Capital with Changed Proportions: It is quite possible that the specific costs of capital of different sources may be affected by the amount of funds' raised and

Marginal weighting system, uses and limitations of the marginal weighting s...

uses and limitations of the marginal weighting system

Traditional yield measures, Current Yield Current y...

Current Yield Current yield is defined as the annual coupon interest received on the market price.          Current Yield =

Share price movements, The management of Nelson plc wish to estimate their ...

The management of Nelson plc wish to estimate their firm's equity beta. Nelson has had a stock market quotation for only two months and the financial management feels that it would

Yield to call, Yield to call is the yield that would be realized on a...

Yield to call is the yield that would be realized on a callable bond assuming the issuer of the bond redeems it before maturity. A bond's call provision is detail

What do you mean by misappropriation of fund, Q. What do you mean by Misapp...

Q. What do you mean by Misappropriation Of Fund? Misappropriation Of Funds allotted for specific works under capital or Revenue demand but the expenditure is incurred for anoth

No title, discuss the steps in the controlling process

discuss the steps in the controlling process

Discuss the different forms of financing, Question 1 Explain the concept ...

Question 1 Explain the concept and phases of capital budgeting Question 2 Define and explain the methods of demand forecasting Question 3 Mention the elements o

Valuation using forward rates, We can discount cash flows either by u...

We can discount cash flows either by using spot rates or forward rates, because a spot rate is simply a package of short-term forward rates. Assume that the cash

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd