00AS AN EXAMPLE, THE PRICE AT NODE A IS OBTAINED AS FOLLOWS

100.00

As an example, the price at node A is obtained as follows:

Price = max{(prob × (P + coupon/2) + prob × (P + coupon/2))/(1 + rate/2), putl price} = max{(0.5 × (100 + 2) + 0.5 × (100 + 2))/(1 +

0.0759/2),98} = 98.27. The bond values at the other nodes are obtained in the same way.

The price at node 0 = [0.5 × (98.27+2) + 0.5 × (99.35+2)]/ (1 + 0.0635/2) = $97.71 but since this is less than the put price of $98 the bond

price will be $98.

Question #68 of 88

Which of the following is the appropriate "nodal decision" within the backward induction methodology of the interest tree framework for a

callable bond?

A)

Min(call price, discounted value).

B)

Max(call price, discounted value).

C)

Min(par value, discounted value).

Explanation

When valuing a callable bond using the backward induction methodology, the relevant cash flow to use at each nodal period is the coupon

to be received during that nodal period plus the computed value or the call price, whichever is less.

Questions #69-74 of 88

Patrick Wall is a new associate at a large international financial institution. Wall has recently completed graduate school with a Master's

degree in finance, and is also currently a CFA Level I candidate. His previous work experience includes three years as a credit analyst at

a small retail bank. Wall's new position is as the assistant to the firm's fixed income portfolio manager. His boss, Charles Johnson, is

responsible for getting Wall familiar with the basics of fixed income investing. Johnson asks Wall to evaluate the bonds shown in Table 1.

The bonds are otherwise identical except for the call feature present in one of the bonds. The callable bond is callable at par and

exercisable on the coupon dates only.

Table 1

Bond Descriptions

Non-Callable Callable Bond

Price $100.83 $98.79

Time to Maturity (years) 5 5

Time to First Call Date -- 0

Annual Coupon $6.25 $6.25

Interest Payment Semi-annual Semi-annual

Yield to Maturity 6.0547% 6.5366%

Price Value per Basis Point 428.0360 --

Wall is told to evaluate the bonds with respect to duration and convexity when interest rates declined by 50 basis at all maturities over

the next six months.

Johnson supplies Wall with the requisite interest rate tree shown in Figure 1. Johnson explains to Wall that the prices of the bonds in

Table 1 were computed using this interest rate lattice. Johnson instructs Wall to try and replicate the information in Table 1 and use his

analysis to derive an investment decision for his portfolio.