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

Foreign bonds, They are issued in the local market, by a foreig...

They are issued in the local market, by a foreign borrower are usually denominated in the local currency. For example, Yankee bonds are USD denominated bon

Why do corporations declare stock splits and stock dividends, What is the e...

What is the effect of stock (not cash) dividends and stock splits on the market price of common stock?  Why do corporations declare stock splits and stock dividends? Stock divi

Define modern approach of financial management, Define Modern Approach of f...

Define Modern Approach of financial management Modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for fina

Types of warrants, Types of Warrants The warrants can be classified int...

Types of Warrants The warrants can be classified into different types. They are: Detachable Warrants These warrants are issued with most debentures, like convertible o

Explain the savage friedman hypothesis, Question: (a) Describe the axio...

Question: (a) Describe the axioms of utility. (b) An economic agent has a logarithmic utility function, U(W) = lnw and has initial wealth $20,000. She is offered the sub

Advantages and disadvantages of aggressive working capital, What are the ad...

What are the advantages and disadvantages of the aggressive working capital financing approach? An belligerent working capital financing approach typically results in a lower c

Evaluate income statement and balance statement, This task must be complete...

This task must be completed in order from 1 to 11 as identified in both the Income Statement and the Balance Sheet. In addition, all answers must cite relevant supporting formulas

Operating cycle, #question application of an operating.cycle in vegetable g...

#question application of an operating.cycle in vegetable growing business.

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