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Chapter 9 – Valuing Bonds with Embedded Options
1.
Binomial Valuation Model: A binomial model is a relatively single factor interest rate model
that, given an assumed level of volatility, suggests that interest rates have an equal probability
of taking on one of two possible values in the next period.
Ex. A 2period Binomial Tree
2.
Backward induction Methodology: Working backward to compute the value of a bond at node
0. Know the value of the bond at the starting node and then work “backwards”.
3.
Valuing a 2 year 7% coupon, option free bond given interest rate at each node.
4.
Valuing a 2year 7% coupon, callable bond, callable in one year at 100
5.
What is the value of the “embedded call option”
6.
What is the value of a putable bond. What is the value of the “embedded put”?
7.
What happens to the value of the callable bond and putable bond as volatility rises?
8.
OAS: Is the interest rate spread that must be added to all of the 1year forward rates in a
binomial tree so that the theoretical value of a callable bond generated with the tree is equal
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This note was uploaded on 11/06/2010 for the course ECON Econ taught by Professor Liasa during the Spring '10 term at University of San Francisco.
 Spring '10
 Liasa
 Interest Rates

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