how do you calculate the interest rate at each particular node if you increase the volatility assumption on a bond that has an embedded option? The example in the text increases from 10% to 20% and I cant wrap my head around where they are coming up with some the figures. (see practice question #3 pg 368 CFA book 5) Thanks!
PQ 3 refers you back to the tree in PQ 1
I get that…and I understand why the price is lower given the higher volatility, but what I dont get is how to incorporate the higher volatility within the calculations to determine the value.
In the example #3B from above, the 10% volatility assumption has a value of $102…899 vs the 20% volatility assumption which has a value of $102.108. where at in the calculation do you factor the assumed increase in volatility??
You are provided the interest rates at the new volatility assumption so you use backward induction to derive the root value of the binomial tree (this is just the normal exercise).
The volatility increase is baked into the interest rates for you already.
so basically if the exam asks us to compare the value assuming a 20% volatility as opposed to a 10% volatility, they will have to provide the interest rates and no deriving on our part is necessary??