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Subject 5. The Monte Carlo Method PDF Download
This method uses pathwise valuation and a large number of randomly generated simulated paths.

Steps:

  • Generate large number of interest rate paths.
  • Determine cash flows along each path. Cash flows can be path dependent. They may depend not only on current level of interest but also the history of interest rates.
  • Discount the path dependent cash flows by the path's interest rates.
  • Repeat present value calculation over all paths.
  • Results of calculations form a "distribution." Theoretical value is based on mean of distribution: average of all paths.

Advantages of Simulation:

  • Type of cash flow distribution may not be clear.
  • Distribution of results provides more information than mean and variance.
  • Can be easier to explain to management.

User Contributed Comments 1

User Comment
myron Mortgage-backed securities have path-dependent cash flows on account of the embedded prepayment option. It should be used for valuing MBS as the binomial tree backward induction process is inappropriate for securities with path-dependent cash flows.
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