Question #16
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 7
Status: Correct
Correct Answer: B
Question
Which of the following is a correct statement concerning the backward induction technique used within the binomial interest rate tree framework? From the maturity date of a bond:
Answer Choices:
A. the corresponding interest rates are weighted by the bond's duration to discount the value of the bond
B. the corresponding interest rates and interest rate probabilities are used to discount the value of the bond
C. a deterministic interest rate path is used to discount the value of the bond.
Explanation
For a bond that has N compounding periods, the current value of the bond is determined
by computing the bond's possible values at period N and working "backwards" to the
present. The value at any given node is the probability-weighted average of the discounted
values of the next period's nodal values.
(Module 26.1, LOS 26.e)
+
+
= 101.15
3.0
(1.02)
3.0
(1.02)(1.02805)
103.0
(1.02)(1.02805)(1.030216)