Question #7
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 3
Status: Incorrect
Correct Answer: A
Your Answer: A
Question
Relative to the binomial model, Monte Carlo method is most likely:
Answer Choices:
A. less flexible in forcing interest rates to mean revert
B. more flexible as it does not need a volatility estimate
C. more suitable when valuing securities whose cash flows are interest rate path dependent
Explanation
Monte Carlo method does not require that cash flows of a security be path independent
and hence is suitable alternative to the binomial model to value securities such as
mortgage backed securities whose cash flows are path dependent. The model generating
interest rates paths in a Monte Carlo simulation is based on an assumed level of volatility
(i.e., model needs a volatility input). The model generating interest rates in a Monte Carlo
simulation can incorporate bounds for interest rates to force mean reversion of rates.
Such bounded optimization is not possible in a binomial model.