- CFA Exams
- 2024 Level II
- Topic 6. Fixed Income
- Learning Module 29. The Arbitrage-Free Valuation Framework
- Subject 5. The Monte Carlo Method
Subject 5. The Monte Carlo Method PDF Download
This method uses pathwise valuation and a large number of randomly generated simulated paths.
- 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
|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.