Hi there,
Am really struggling to calculate the value of callable & putable bonds (V0). I have analysed the answers (tree diagrams) but am still finding it difficult to understand how they calculated the values.
I have tried to attach photos to this post (however, am having problems trying to do this), so please refer to questions 4 & 5 from the CFA textbook under reading 37 Valuation & Analysis. Likewise, if someone can suggest how I can add screenshots to this post - I will do that.
If someone could write out formulas used (with numbers inserted) so I can trace how final value figure was calculated, it would be most appreciated.
Many thanks,
Jamie
It is quite hard to write all that out but essentially do the following:
Find out what the coupon is on the Put. Lets say it 4.25%
Then, starting from the far right and assuming the par is 100 we take 104.25 (as this is the final payment) and we discount it back at the preceding node interest rate. If the number calculated here is out the money then we add the 4.25 coupon on. If the rate calculated is IN the money, we excercise the option and add the coupon rate to the excercise rate.
Repeat this process down the far right hand column.
Once you then have values for the nodes left of the far right (these will either be coupon + calc value) OR (coupon + EXCERCISE VALUE) we will then add the two values together (say top node and middle node… divide that by 2 and then take that number and repeat the process discounting at the next node to the left. Here repeat process to either add coupon to the calc value OR if it is in the money, coupon + excercise value)
Work down this column of nodes and once again add the two values together, divide by 2 and then divide by the first node.
At the first node we DO NOT add back the coupon as this is Time 0. The answer will equate to one of the options
Put options don’t have coupons.
Bonds do. Options don’t.
Yes apologies i knew that, was just writing fast without proof checking