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

Explain hedging transaction exposure, Discuss and compare hedging transacti...

Discuss and compare hedging transaction exposure by using the forward contract vs. money market instruments. While do the alternative hedging approaches generate similar result?

Propose which investment plan, Problem There are two investment plans i...

Problem There are two investment plans in the market whose details are given below based on which you need to decide which investment plan you need to select. Propose which inv

Calculation of variances, a) Distinguish among standard costing and budgeta...

a) Distinguish among standard costing and budgetary control.  (b)"Calculation of variances in standard costing is not an end in itself, but a means  to an end" Brief discussion

Spot transaction hedge/Money market hedge, There are three parts to this qu...

There are three parts to this question. Please answer all parts. The Chicken Company, a company with headquarters in Switzerland, has a receivable of one million euro, which it wil

Venn diagram, d iscuss the relationship between finance management,economic...

d iscuss the relationship between finance management,economics,accounting, and mathematics. illustrate/show through a venn diagram

Domestic bonds, They are issued in the local market by a domestic bor...

They are issued in the local market by a domestic borrower and are usually denominated in the local currency. For example, US companies issuing bonds to US reside

Components of working capital, Examine the components of working capital & ...

Examine the components of working capital & also explain the concepts of working capital.

What are the techniques of financial management, What are the techniques of...

What are the techniques of financial management There are two widely-discussed techniques: (i) Profit maximisation approach and (ii) Wealth maximisation approach.

Basic methods of risk management, Q. Basic Methods of Risk Management? ...

Q. Basic Methods of Risk Management? Risk is inherent in business and hence there is no escape from the risk for a businessman. However, he may face this problem with greater c

The process of review and audit of internal control systems, The process of...

The process of review and audit of internal control systems The board of directors are responsible for review and maintenance of internal controls. Management  of  the  company

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