- CFA Exams
- CFA Level I Exam
- Study Session 12. Fixed Income (1)
- Reading 33. The Arbitrage-Free Valuation Framework
- Subject 6. Monte Carlo Method

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**CFA Practice Question**

Using Monte Carlo simulation for valuing a mortgage backed security means the generation of

A. a set of different cash flows based on different assumed interest rates, add them up, and then discount them back to the present.

B. a series of interest rate paths to be used to discount cash flows calculated along the paths.

C. a multi-level cash flow tree and cash flows are discounted at different short-term rates.

**Explanation:**The model simulates potential interest rate paths and incorporates an interest rate volatility estimate. How prepayment speed and the mortgage bond's cash flows react to changing interest rates is also modeled. The analyst then runs a simulation. Each simulation produces a possible interest rate path (actually an evolution of the whole yield curve) and a possible value for the mortgage bond, arrived at by discounting simulated cash flows at today's rates.

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