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The following is a review of Lhe Market Risk Measurement and Management principles designed to address the learning objectives set forth by GARP 1’ . Cross-
reference to GARP assigned reading— Turkman and Serrat, Chapter 7.

READING 11: The Science of Term Structure Models

Study Session 3

EXAM FOCUS
The emphasis of this reading is the pricing of interest rate derivative contracts using a risk -neutral binomial model. The pricing process
for interest rate derivatives requires intensive calculations and is very tedious. However, the relationship becomes straightforward when
i t is modeled to support risk neutrality. Understand the concepts of backward induction and how the addition of time steps w i l l increase
the accuracy of any bond pricing model. Bonds with embedded options are also discussed i n this reading. Be familiar with the price-
yield relationship o f both callable and putable bonds. This reading incorporates elements of material from the FRM Part I curriculum
where you valued options with binomial trees.

MODULE 11.1: INTEREST RATE TREES AND RISK-NEUTRAL PRICING

L O 11.a: Calculate the expected discounted value of a zero-coupon security using a binomial tree.

L O 11 .b: Construct and apply an ar bitrage argument to price a call option on a zero-coupon security using replicating
portfolios.

The binomial interest rate model is used throughout this reading to illustrate the issues that must be considered when valuing bonds with
embedded options. A binomial model is a model that assumes that interest rates can take only one of two possible values in the next
period.

This interest rate model makes assumptions about interest rate volatility, along with a set of paths that interest rates may follow over
time. This set of possible interest rate paths is referred to as an interest rate tree.

Binomial Interest Rate Tree

The diagram i n Figure 11.1 depicts a binomial interest rate tree.

to

Today Period I Period 2

To understand this 2-period binomial tree, consider the nodes indicated with the boxes in Figure I L L A node is a point in time when
interest rates can take one of two possible paths— an upper paih, U, or a lower path. L . Now consider the node on the right side o f the
diagram where the interest rate i 2 hj appears. This is the rate that w i l l occur i f the initial rate, i 0 , follows the tower path from node 0 to
node 1 to become J t L , then follows the upper of the two possible paths to node 2, where it takes on the value f 2 LU . At the risk o f
stating the obvious, the upper path from a given node leads to a higher rate than the lower path. Notice also that an upward move
followed by a downward move gets us to the same place on the tree as a down- then-up move, so i 2 L U = 2.UL ■
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The interest rates at each node in this interest rate tree are 1 -period forward rates corresponding to the noda] period. Beyond the root of
the tree, there is more than one 1-period forward rate for each nodal period (i.e. F aL year 1. we have two 1-year forward rates, i | n and
i] L ). The relationship among the rates associated with each individual noda] period is a function o f the interest rate volatility
assumption o f the model being employed to generate the tree.

Constructing the Binomial Interest Rate Tree

The construction o f an interest rate tree, binomial or otherwise, is a tedious process. In practice, the interest rate tree is usually
generated using specialized computer software. There is one underlying rule governing the construction of an interest rate tree: The
values for on-the-run issues generated using an r rife?rest rate tree shou/d prohibit arbitrage opportunities. This means that the value of
an on-the-run issue produced by the interest rate tree must equal its market price. I t should be noted that i n accomplishing this, the
interest rate tree must maintain the interest rate volatility assumption of the underlying model.
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Valuing an Option-Free Bond With the Tree, Using Backward Induction

Backward induction refers to the process o f valuing a bond using a binomial interest rate tree. The term “backward” is used because in
order to determine the value of a bond at node 0, you need to know the values that the bond can take on at node 1. But to determine the
values of the bond at node 1, you need to know the possible values of the bond at node 2, and so on. Thus, for a bond that has
N compounding periods, the current value o f the bond is determined by computing the b o n d s possible values at period N and working
“backward” to node 0.

Consider the binomial tree shown in Figure 1 1.2 for a S100 face value, zero-coupon bond, with two years remaining until maturity, and
a market price of $90,006. Starting on tine top tine, the blocks at each node include the value of the bond and the 1-year forward rate at
that node. For example, at the upper path of node 1, the price is $93,299, and the 1-year forward rate is 7. 1826%.

Figure 11.2: Valuing a 2- Year, Zero-Coupon, Option-Free Bond

$ 100.01)

$93,299
7.1826%
$100.00
$90,006
4.5749%
$100.00
$94,948
53210%

$100.00

Today End of 1 year

Know that the value of a bond of o g/vcn node rn n binomiai tree is the average of the present values of the two possible values from the
next period. The appropriate discount rate is the forward rate associated with rhe node under analysis.

EXAMPLE: Valuing an option-free bond

Assuming the bond's market price is $90,006, demonstrate iha! the tree i n Figure 1L2 is arbitrage iree using backward induction.
Answer:
Consider the value of the bond al the upper node lor period 1, V L jp
tvt l S100 <0.5) !-|.J100x0.5) ( Q I
t,u = ---------, -------- = i b y j j y y
Similarly the value of the bond at the lower node for period 1, V| L is:
v. l L_ —_ _ S94 g 4 8
* - 1.05J210
Mow calculate Vo , the current value of the bond al node 0:

Vo = I . ' . N J i J i*
= $90,006
Since the computed value of the bond equals the market price, the binomial tree is arbitrage free.

PROFESSOR’S NOTE

When valuing bonds with coupon payments> you need to add the coupons to the bond prices at each node. For example, with a $ 100
face value, 7% annual coupon bond, you would add the $7 coupon to each price before computing present values. Valuing coupon-
paying bonds with a binomial tree w i l l be Illustrated i n L O 1 t.e.

LO 11,c: Define risk-neutral pricing and apply it to option pricing,

LO 11.d: Distinguish between true and risk-neutral probabilities and apply this difference to interest rate drift.
Using the 0.5 probabilities for tip and down states as shown i n the previous example may not produce an expected discounted value that
exactly matches tlie market price of the bond. This is because the 0.5 probabilities are the assumed true probabilities of price
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movements. In order to equate the discounted value using a binomial tree and the market price, we need to use what is known as risk-
neutral probabilities. A n y difference between the risk- neutral and true probabilities is referred to as the interest rate drift.

Using the Risk-Neutral Interest Rate Tree

There are actually two ways to compute bond and bond derivative values using a binomial mode]. These techniques are referred to as
risk-neutral pricing.

■ The first mediod is to start with spot and forward rates derived from the current yield curve and ihen adjust fhe interest rates on
the paths of the tree so that the value derived from the model is equal to the current market price of an on -the -run bond [i.e., the
tree is created to be "arbitrage free"). This is the method we used i n the previous example. Once lhe interest rate tree is derived
for an on-the-run bond, we can use it to price derivative securities on the bond by calculating the expected discounted value at
each node using the real-world probabilities.
■ The second mediod is to take the rates on the tree as given and then adjust rhe probabilities so that the value of the bond derived
from the mode] is equal to its current market price. Once we derive these risk-neutral probabilities, we can use them to price
derivative securities on the bond by once again calculating the expected discounted value at each node using the risk-neutral
probabilities and working backward through the tree.

The value of the derivative is the same under either method.

<2> MODULE QUIZ 11.1

I ~ 1. Which of the following statements concerning the calculation of value at a node in a fixed- in come binomial interest rate tree
is most accurate? The value at each node is:
A_ the present value of the two possible values from the next period.
B. the average of the present values of the two possible values from the next period.
C. the sum of the present values of the two possible values from the next period.
D. the average of the future values of the two possible values from the next period.

MODULE 11.2: BINOMIAL TREES

LO 11,e: Explain how lhe principles of arbitrage pricing of derivatives on fixed income securities can be extended over multiple
periods.

There are three basic steps to valuing an option on a fixed-income insuument using a binomial tree:

Step 1 : Price the bond value at each node using the projected interest rates.

Step 2: Calculate the intrinsic value of the derivative al each node at maturity.

Step 3: Calculate the expected discounted value of the derivative at each node using the risk-neutral probabilities and working backward
through the tree.

Note that the option cannot be properly priced using expected discounted values because the call option value depends on the path of
interest rates over the life o f the option, incorporating lhe various interest rate paths w i l l prohibit arbitrage from occurring.

EXAMPLE: Call option

Assume that you want to value a European call option with two years to expiration and a strike price of 3100.00. The underlying is a 7%,
annual-coupon bond with three years to maturity. Figure 11.3 represents lhe first two years of the binomial tree for valuing the underlying
bond. Assume that lhe risk-neutral probability of an up move is 0.76 i n year I and 0.60 i n year 2.
Fill in the missing data i n the binomial tree, and calculate lhe value of the European call option.

PROFESSOR’S NOTE:

Since lhe option is European, Lt can only be exercised al maturity.

Figure 11.3: Incomplete Binomial Tree for European Call Option on 3- Year, 7% Bond
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Ini. rate - ft.56%

Bond price - S9S56
060
Option value « ?
Im. rate * 5.99%
Bond price - ?
Option value - ?
Ini. rate = 6.34%
Im. rate = 3,00% 0.40 Bond price = ?
Rond price = ? Option value * ?
0 60
Option value =■ ?
Im. m e ■ 4.44%
0.24 Bond price - ?
Oprion value ■ ? \. [nt. rate - 4-70%
i Bond price - ?
0.40 Option value =■ ?

Today End of I year End of 2 yean

Answer:
Step 1: Calculate the band prices at each node using the backward induction methodology. Remember to add the 7% coupon payment to the
bond price at each node when discounting prices.
At the middle node i n year 2, the price is 5100.62. You can calculate this by noting that al the end of year 2 the bond has one year left to
maturity:
N = 1; I/Y = 6.34: PMT = 7: FV = 100: CPT - PV = 100.62
Al the boltom node i n year 2, the price is SI 02. 20:
N = 1: ]/Y = 4.70: PMT = 7: FV = 100; CPT — P V = 102.20
At the Lop node in year 1. the price is 5100.37:
($105.56 x 0.6) + ($107.62 x 0.4)
= $100.37
At the boltom node In year J, the price is S I 03.65:
($107.62 x 0.6) +($109.20 x 0.4)
1 0444 = $103.65
Today, the price is S I 05.0 1:
($107.37 x 0.76) + ($110.65 x 0.24)
Q3 = $105.01
As shown here, the price at a given node is the expected discounted value of the cash flows associated with the two nodes that “feed” into that
node. The discount rate that is applied is the prevailing interest rate at the given node. Note that since this is a European option, you really
only need the bond prices at the maturity date of the option {end of year 2.) i f you are given the arbitrage-free interest rate tree. However, it's
good practice lo compute ah the bond prices.
Slep2.‘ Determjne the intrinsic value of the option ut maturity in each node. For example, the intrinsic value of the option at the bottom node
at the end of year 2 is $2.20 = $102.20 - SJ 00.00. A l the top node in year 2, the intrinsic value of the option is zero since the bond price is
less than the call price.
Step 3: Using the backward induction methodology, calculate the option value at each node prior to expiration. For example, at the top node
for year L , the option price is SO.23:
($0.00 x 0.6) + {$0.62 x 0.4)
1023
1.0599
Figure 1 L.4 shows the binomial tree with all values included.
Figure 11.4: Completed Binomial Tree for European Call Option on 3-Year, 7% Bond
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lnt. rate - 8.56%

Bond price ■ $98.56
0.60
* Option value = $0.00
lnt. tire -
0 76 B° n < Pr ’« * $100.37
Option value = $0.23
lnt. rate - 6 34%
lnt. rate * 3-00% 0.40 Bond prior - $100-62
Bond price - $105-01
0.60 Option value - $0.62
Option value = $0.45
luc. rate ■ 4 44%
0.24 Bond price - S103.65
Opxion value = $ t 2 0 lnt. rare = 4.70%
Bond price = $102-20
0‘40 Option value $2.20

Today End nF 1 year End o f 2 year*

The option value today is computed as:

IW J x.a.Ttil ; (U .20 tt.2 i i = 45

Recombining and Nonrecombining

L O I L g : Describe the rationale behind the use of recombining trees in option pricing,

In the previous example, the interest rate in the middle node of period two was the same (i.e. P 6.34%) regardless of the path being up
then down or down then up. This is known as a recombining tree, fl may be the case, i n a practical setting, that the u p then down
scenario produces a different rate than the down-then-up scenario. An example of this type of tree may result when any interest rate
above a certain level (e.g., 3%) causes rates to move a fixed number of basis points, but any interest rate below that level causes rates to
move at a pace that is below tlie up state's fixed amount. When rates move in this fashion, the movement process is known as state-
dependent volatility, and it results i n nonrecombining trees. From an economic standpoint, nonrecombining trees are appropriate;
however, prices can be very difficult to calculate when the binomial tree is extended to multiple periods.

Constant Maturity Treasury Swap

* V
LO l l . h : Calculate the value of a constant maturity Treasury swap, given an interest rate tree and the risk-neutral probabilities.

In addition to valuing options with binomial interest rate trees, we can also value other derivatives such as swaps. The following
example calculates the price of a constant maturity Treasury (CMT) swap. A C M T swap is an agreement to swap a floating rate for a
Treasury rate such as the 10-year rate.

EXAMPLE: C M T swap

Assume that you want to value a constant maturity Treasury (CMT) swap. The swap pays the following every six months until maturity:

a
ycMT semiannually compounded yield, of a predetermined maturity, at the Lime of payment (ycMT equivalent to 6-month spot rates).
Assume there is a 7&% risk-neutrai probability of an increase in the 6-month spot rate and a 60% risk-neutral probability of an increase in the
1-year spot rate.
F i l l i n ihe missing data i n die binomial tree, and calculate the value of the swap.
Figure 11.5: Incomplete Binomial Tree for CMT Swap
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Im. rare = 7.50%

0.60 Swap price = ?

Ini. rate » 7.25%

0.76 Swap price ■ ?
Ini . rate = 7.00%
I nt. rate = 7-00% 0.40 Swap price ■ ?
Swap price = ? 0.60
Im. rate - 6.75%
0.24 Swap price = ?
Im. rate ■ 6.50%
Swap price » ?
0.40

.Six MihhIis

Answer:
I n six months, the top node and bottom node payoffs are. respectively:
51,000,000 / ( x
payoffi u = --------- -------- < ( 7 . 2 5 % - 7.00%) = $1,250

$1,000,000 /
payoff 1L = — — j -------- x (6.75% - 7.00%) = -$1,250

Similarly in one year, the top, middle, and bottom payoffs are, respectively:
$1,000,000 z *A
payoff 2<u = 2 ------ X f 7.50% — 7-00%) = $2,500

$1,000,000 / „ \
payoff IM = 2 ------ x (7.00% - 7.00%) = $0

4 1 i'i i i 11 111ir i
payoff; L = ’ 2 ' ------ x (6.50% - 7-00%) = - $ 2 , 500

the 6-month payoffs {SI ,250 and - S i ,2 0). Hence, the 6-month values for the top and bottom node arc. respectively:
V i v = i -«- or.: -i o.i; S 1 950 = J2, 697-53
1
. . o.oza
<y
( $ 0 x 0 . 6 ) + ( - $ 2 , 500 x 0.4)
-------------, O.0675\ --------$1,250 = -$2,217.35
1+
------2
Today the price is Si .466.63, calculated as follows;
($2,697.53 x 0 . 7 6 ) + ( - $ 2 , 217.35 x 0.24)
Vo ----------------------------— 7 ---------------------------- $1,466.63
1 n

Figure 11.6 shows the binomial tree with all values included.
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Inr. rare = 7.50%

Swap price ■■
0.60
$2,500.00
I n t . rate = 7.25%
0.76 Swap price =
S2.697.53
Irir. rate = 7-Ot)*Ki
Im. rue ■ 7.00% 0.40 Swap price =
Swap price = $0
0 60
S3 .466 63
Ini. rate 6.75%
0.24 Swap price -
-S2.2I7.35 Inr. raTt = 6.50%
Swap price -
-42.500.00

Today Six Months One Year

MODULE QUIZ 11.2

I — It 1. A European put option has two years to expiration and a strike price of $101.00. The underlying is a 7% annual coupon
bond with three years to maturity. Assume that the risk-neutral probability of an up move is 0.76 in year 1 and 0.60 in year 2.
The current interest rate is 3.00%. At the end of year 1. the rate will either be 5.99% or 4.44%. If the rate in year 1 is 5.99%,
it will either rise to 8.56% or rise to 6.34% in year 2. if the rate in one year is 4.44%. it will either rise to 6.34% or rise to
4.70%. The value of the put option today is closest to:
A $1.17.
B. $1.30.
C. $1.49.
D. $1.93.

MODULE 11.3: OPTION-ADJUSTED SPREAD

L O 111: Define Op den- Adjusted Spread ( D A S ) and apply it to security pricing.

The option -adjusted spread (OAS) is the spread that makes the model value (calculated by the present value of projected cash flows)
equal to the current market price. In the previous CMT example., the mode] price was equal to $1,466.63. N o w assume that the market
price of the C M T swap was. instead S I .464.40, which is $2.23 less than the model price. In this case, the O A S to be added to each
discounted risk-neutral rate i n the CMT swap binomial tree turns out to be 20 basis points. In six months, the rates to be adjusted are
7.25% in the up node and 6.75% i n the down node, incorp orating the O A S Into the six-month rates generates the following new swap
values:

Vv i , u -— ( $ 2 , 5 0 0 ,xO.a-)+(S0xQ-4)
0 -4— i 2o0 — $2, 696.13
1
2

($0 x 0.6)-|-(- $2, 500 x 0.4)

A 250
V r L = ------------- 0 0695 ------------- ~ = $ 2 ’ 216-42
1+
T“

Notice that the only rates adjusted by the OAS spread are the rates used for discounting values. The O A S does not impact the rates used
for estimating cash flows. The final step i n this C M T swap valuation is to adjust the interest rate used to discount the price back to
today. In this example, the discounted rate of 7% is adjusted by 20 basis points to 7.2%. The updated initial CMT swap value is:

v
($2, 696.13 x 0 . 7 d ) + ( - $ 2 1 216.42 x 0.24)
o = -----------------------------~ O72------------------------- = $1,464.40
1
~ 2

N o w we can see that adding the OAS to the discounted risk-neutral rates in the binomial tree generates a model price ($1,464.40) that is
equal to the market price (S1.4S4.40). I n this example, the market price was initially less than the model price. This means that the
security was trading cheap. I f (he market price were instead higher than the model price we would say that the security was trading rich.

Time Steps
L O 11.i : Evaluate the advantages and disadvantages of reducing the size of die time steps on the pricing of derivatives on fixed-
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income securities.
For the sake of simplicity, the previous example assumed periods of six months. However, in reality, the time between steps should be
much smaller. As you can imagine, the smaller the time between steps, the more complicated the tree and calculations become. Using
daily time steps w i l l greatly enhance the accuracy o f any model but at the expense of additional computational complexity;

Fixed-Income Securities and Black-Schoies-Merton

LO 11 J : Evaluate the appropriateness of the Black-Schoies-Merton model when valuing derivatives on fixed income securities.

The Black-Schoies-Merton mode] is the most well-known equity option pricing model. Unfortunately, the mode] is based on three
assumptions that do not apply to fixed-income securities:

1. The model's main shortcoming is that it assumes there is no upper l i m i t to the price of the underlying asset. However, bond
prices do have a maximum value. This upper limit occurs when interest rates equal zero so that zero-coupon bonds are priced at
par and coupon bonds are priced at tine sum o f the coupon payments plus par.
2. I t assumes the risk-free rate is constant. However, changes in short-term rates do occur, and these changes cause rates along the
yield curve and bond prices to change.
3. I t assumes bond price volatility is constant. W i t h bonds, however, price volatility decreases as the bond approaches maturity.

Bonds With Embedded Options

Fixed-income securities are often issued with embedded options, such as a call feature. In this case, the price-yield relationship will
change, and so will the price volatility characteristics o f the issue.

Callable Bonds
A call option gives the issuer the right to buy back the bond at fixed prices at one or more points in the future, prior to the date of
maturity. Since the investor takes a short position in the call, the right to purchase rests with the issuer. Such bonds are deemed to be
callable (note that a call provision on a bond is analytically similar to a prepayment option).

Figure 11.7: Price- Yield Function of Callable Bond

Prict

call
price

□priori' free bond

callable b o n d

Yield

For an option-free noncallable bond, prices w i l l fall as yields rise, and prices w i l l rise unabated as yields fail— in other words, they’ll
move in line with yields. That's not the case, however, with callable bonds. As you can see in Figure 11.7, the decline in callable bond
yield w i l l reach the point where the rate of increase in the price of the callable bond will start slowing down and eventually level off.

This is known as negative convexity. Such behavior is due to the fact that the issuer has the right to retire the bond prior to maturity at
some specified cal] price. The call price, in effect, acts to hold down the price o f the bond (as rates fail) and causes the
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price-yield curve to flatten. The point where the curve starts to flatten is at (or near) a yield level of y Note that as long a s
yields remain above y r, a callable bond will behave like any option-free (noncallable) issue and exhibit positive convexity.
That’s because at high yield levels, there is little chance of the bond being called.
Below y investors begin to anticipate that the firm may call the bond, in which case investors will receive the call price. Therefore, as
yield levels drop, the bond's market value is bounded from above by the call price. Thus, callability effectively caps the investor’s
capital gains as yields fa]]. Moreover,, i t exacerbates reinvestment risk since i t increases the cash flow that must be reinvested at lower
rates (i.e.. without the call or prepayment option., the cash flow will only be the coupon; with the option, the cash flow is the coupon
p]us the call price).

Thus, in Figure 11.7, as long as yields remain below y r, callable bonds will exhibit price compression, or negative convexiry; however,
at yields above y \ those same callable bonds will exhibit all the properties of positive convexity.

Putable Bonds
The put feature in putable bonds is another type of embedded option. The put feature gives the bondholder the right to sell the bond
back to the issuer at a set price (i.e., the bondholder can “put 11 the bond to the issuer). The impact of the put feature on the price-yield
relationship is shown i n Figure 11.8.

Figure 11.8: Price- Yield Function of a Putable Bond

Price
Option-Free Bond

Putable Bond

Pul
Price

Yield

Al low yield levels relative to the coupon rate, the price-yield relationship of putable and nonputable bonds is similar. However, as
shown in Figure i 1.8. if yields rise above y r, the price of the putable bond does not fall as rapidly as the price of the option-free bond.
This is because the put price serves as a floor value for the price of [he bond.

MODULE QUIZ 11.3

1. The Black-Scholes -Merton option pricing model is not appropriate for valuing options on corporate bonds because
corporate bonds:
A_ have credit risk.
B. have an upper price bound.
C. have constant price volatility.
D. are not priced by arbitrage.
2. Which of the following regarding the use of small time steps in the binomial model is true?
A Less realistic model.
B. More accurate model.
C. Less complicated computations.
D. Less computational expense.
3. Which of the following statements about callable bonds compared to noncallable bonds is false?
A They have less price volatility.
B. They have negative convexity.
C. Capital gains are capped as yields rise.
D. At low yields, reinvestment rate risk rises.
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KEY CONCEPTS

LO 11 .a
Backward induction methodology with a binomial model requires discounting of the cash flows that occur at each node in an interest
rate tree (bond value plus coupon payment) backward to the root of the tree.

LOll.b
The values for on-the-run issues generated using an interest rate tree should prohibit arbitrage opportunities.

LO ll.c
Risk-neutral, or no-arbitrage, binomial tree models are used to allow for proper valuation of bonds with embedded options.

LO n.d
Using the average o f present values o f the two possible values from the next period may not produce an expected discounted bond value
that exactly matches the market price of the bond.

Using 0.5 probabilities for up and down states are the assumed true probabilities o f price movements. ] n order to equate the discounted
value using a binomial tree and the market price, we need to use risk-neutral probabilities.

LO ll.e
To value an option on a fixed-income instrument using a binomial tree:

1. Price the bond at each node using projected interest rates.

3. Calculate the expected discounted value of the derivative at each node using the risk-neutral probabilities and working backward
through the tree.

Callable bonds can be valued by modifying the cash flows at each node i n the interest rate tree to reflect the cash flow prescribed by the
embedded call option.

LO ll.f
The option-adjusted spread (OAS) allows a security’s model price to equal its market price, ft is added to any rate in the interest rate
tree that is used for discounting puiposes. y

LO ll.g
Nonrecombining trees result when the up-down scenario produces a different rate than the down-up scenario.

l o n.h w
A constant maturity Treasury ( C M T ) swap is an agreement to swap a floating rate for a Treasury rate.

LOU.i
The precision of a model can be improved by reducing the length of the time steps, but the tradeoff is increased complexity.

LO ll.j
The Black-Scholes-Merton mode] cannot be used for the valuation o f fixed-income securities because i t makes the following
unreasonable assumptions:

■ There is no upper price bound.

■ The risk-free rate is constant.
■ Bond volatility is constant.
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ANSWER KEY FOR MODULE QUIZZES

Module Quiz 11.1

1. B The value at any given node in a binomial tree is the average present value of the cash flows at the two possible states
immediately to the right of the given node, discounted at the 1-period rate at the node under examination. (LO 11. a)

Module Quiz 11.2

1. A This is the same underlying bond and Interest rate tree as in the cal] option example from this reading. However, here we are
valuing a put option.
The option value in the upper node at the end of year 1 is computed as:
(S2.44x0.fi) + ( $ 0 . 3 8 x 0 . 4 )
= 81,52
1.0599
The option value in the lower node at the end of year 1 is computed as:
0.6) + ($0.00 x 0.4)
80,22
1.0444 “
The option value today is computed as:
($1.52 x 0.76) + ($0.22 x 0.24)
1.0300 -81.17
(LO l l . e )

Module Quiz 11.3

assumptions, which are not reasonable for valuing fixed-income securities:

■ There is no upper price bound.
■ The risk-free rate is constant.
■ Bond volatility is constant.
(LO ll.j)

2. B The use of small time steps in the binomial model yields a more realistic model, a more accurate model, more complicated
computations, and more computational expense. (LO 11. i)

3. C Callable bonds have the following characteristics:

■ Less price volatility.
■ Negative convexity.
■ Capita] gains are capped as yields falL
■ Exhibit increased reinvestment rate risk when yields fall.
(LO ll.j)