Question #9
Reading: Reading 26 The Arbitrage-Free Valuation Framework
PDF File: Reading 26 The Arbitrage-Free Valuation Framework.pdf
Page: 4
Status: Correct
Correct Answer: A
Question
A binomial model or any other model that uses the backward induction method cannot be used to value a mortgage-backed security (MBS) because:
Answer Choices:
A. the cash flows for an MBS only depend on the current rate, not the path that rates have followed
B. the cash flows for the MBS are dependent upon the path that interest rates follow
C. the prepayments occur linearly over the life of an interest rate trend (either up or down)
Explanation
A binomial model or any other model that uses the backward induction method cannot be
used to value an MBS because the cash flows for the MBS are dependent upon the path
that interest rates have followed.