Is Kaplan trying to say, “You will inscribe in the tree the higher of either the put price or the discounted value” from its “Max(put price, discounted value” answer choice?
Think of the put price as a floor on the bond’s value. At low interest rates, a putable will act like an option free bond and discounted value>put price; at high enough interest rates, then discounted value<put price.
Why does Kaplan use the word “Max”? Max of what?
Maximum of the 2 figures in the brackets. Try it out in Excel!! MAX(#1, #2)!!!
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Basically it is saying that the value of the node will be either be the maximum of (meaning the higher of) either the put price or the discounted value of the next two attached nodes.
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Thank you for both explanations gentlemen.
They’re saying that the bondholder is not an idiot: they’ll make the decision that gives them the highest possible cash flow.
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Your constant references to cashflow when trying to explain binomial trees is key.
I’m fixated.
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Think of the put price as a floor on the bond’s value. At low interest rates, a putable will act like an option free bond and discounted value>put price; at high enough interest rates, then discounted value<put price.
Think of the put price as a floor on the bond’s value. At low interest rates, a putable will act like an option free bond and discounted value>put price; at high enough interest rates, then discounted value<put price.
