Chapter 9 - Chapter 9 Valuing Bonds with Embedded Options 1...

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1 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 2-period 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 2-year 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 1-year forward rates in a
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