Backward induction
Valuing an instrument on a tree by starting at maturity, where cash flows are known, and working back node by node: average the next values plus cash flows, then discount at that node's rate.
Where you will meet it
Backward induction appears in 2 learning outcomes on the CFA syllabus. A few of them:
- Explain valuation by backward induction, and use it to value a fixed-income instrument from its cash flow at every node
“Backward induction starts at maturity, where the cash flow is known, and works back one date at a time.”
- Explain pathwise valuation within a binomial interest rate model, and use it to value a fixed-income instrument from its cash flows on every path
“Because each path is equally likely, the simple average equals the backward-induction value.”
Practise it
Practise backward induction until it is automatic: questions that explain every wrong option.
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