CFA CFA Level 2 Question on Kaplan’s question on Binomial Trees

Question on Kaplan’s question on Binomial Trees

  • Author
    Posts
  • BobBarkerPlaysPlinko
    Participant
    Up
    3
    Down

    An example of a standard tree used by FIData is given in Figure 2.

    Figure 2: Binomial Interest Rate Tree

    Year 0 Year 1
    4.5749% 7.1826%
    5.3210%

    FIData’s website uses rates in Figure 2 to value a two-year, 5% annual-pay coupon bond with a par value of $1,000 using the backward induction method.

    The question is: Using the backward induction method, the value of the 5% annual-pay bond using the interest rate tree given in the three bonds in Figure 2 is closest to:

    A)$900.
    B)$945.

    C)$993.

    So I averaged node U2 (1005/1.071826) and node L2 (1005/1.05321) to come up with 943.6846.  Then I discounted that by the year 0 rate of 4.5749% and came up with 907.1819.  I answered A.  

    Kaplan says the answer is C.  Their explanation is:  The value of the 5%, two-year annual pay $1000 par bond is $992.88.

    I find that explanation underwhelming.  Can someone help me out here?  Where did I screw up?

    Sophie Macon
    Keymaster
    Up
    4
    Down

    Hi @BobBarkerPlaysPlinko, here’s my method:

    I’ve ignored the $ value of the bond for now, and work on a % basis (of par) to simplify things:

    Using your definition of nodes:
    U2 = 105/1.071826 = 97.9637
    L2 = 105/105321 = 99.6952

    Then fair value of bond today, V0 = 0.5 * [(97.9637+5)/1.045749] + 0.5 * [(99.6952+5)/1.045749]
                                                        = 0.5 * [98.4593+100.1150]
                                                        = 99.2872

    So 99.2872% of a par value of $1,000 should be $993, i.e. answer C. 

    Hope this helps!

Viewing 2 posts - 1 through 2 (of 2 total)
  • You must be logged in to reply to this topic.