Calibrating a Binomial Interest Rate Tree
The following steps should be followed when calibrating binomial interest rate trees to match a particular term structure: Step 1: Estimate the appropriate spot and forward rates for a known par value curve. Step 2: Construct the interest rate tree…
Backward Induction
Backward induction involves working backward from maturity to time 0 to determine a bond’s value at each node. It makes the following assumptions: The value of a bond is known at maturity (Final coupon payment + Face value). The value…
Binomial Interest Rate Model
Modeled future interest rates can take on different possible values, depending on the level of volatility assumed. This can be shown using an interest rate tree framework. One of the most popular tools used is the binomial interest rate model….
The Gordon Growth Model
The Gordon growth model assumes that dividends grow indefinitely at a constant rate. $$D_t= D_{t-1} (1+g)$$ Where: \(g =\) Expected constant growth rate in dividends \(D_{t}=\) Expected dividend at time t. At any time \(t\), \(D_{t}=\) equals dividends at \(t =…
The Dividend Discount Model
Single Holding Period The cash flows to an investor who holds shares are the dividends paid and the market price of the share when they sell the share. For example, suppose an investor expects to hold the share for one…
Arbitrage Free Value
Bonds can be valued either using the traditional valuation approach or the arbitrage-free valuation approach. Under the traditional valuation approach, a single interest rate is used to discount all of a bond’s cash flows. In this approach, all cash flows of…
Present Value Models
Return on Invested Capital and Competitive Advantage
Arbitrage-Free Valuation of a Fixed Income Security
Arbitrage free valuation is an approach that determines bond values based on the assumption that arbitrage opportunities do not exist. The arbitrage-free valuation model is based on the law of one price, which states that two goods, which are perfect…
Maturity Structure of Yield Volatilities
Bond managers must quantify interest rate volatilities for bonds with embedded options because their values depend on the level of interest rate volatilities. Additionally, mitigating the effect of interest rate volatilities on a bond’s price volatility is part of risk…
