Can't read anymore.....

Straight from Schweser’s explanation of LOS 61c:
The cash flows and value of MBS are interest-rate-path-dependent, which means they must be valued with a Monte Carlo Model rather than a binomial model or any other model that employs the backward induction methodology. The cash flows for passthrough securities are a function of prepayment rates, and prepayment rates in any given month are affected by interest rates in the past. There are two sources of path dependency:
If mortgage rates trend downward over a period of time, prepayment rates will increase at the beginning of the trend as homeowners refinance their mortgages; but prepayments will slow as the trend continues, because many of the homeowners that can refinance will have already done so. This prepayment pattern is called prepayment burnout, and it applies to MBS and other types of passthrough security cash flows.
The cash flows that a particular tranche receives in any one month depend on the outstanding principal balances of the other tranches in the structure, which in turn depend on the prepayment history and the interest rate path.
 
Thankfully the real exam writers don’t twist you too much with the double negative BS.
 
so….does anyone wanna volunteer to email schweser about this…
YOU could save a dozen threads next year…if some other genius comes across the same question in the qbank!!
 
dinner time…see ya’ll in a few hours….
there better be a few volunteers by the time I get back!
 
The answer is D and the explanation verifies that the question was just incorrectly stated. As it was originally written it was a double negative. It should of asked what was the MOST likely reason that backward induction cannot be used….just read their explanation.
It needs an errata.
 
Ok. I missed their explanation. That makes sense.
Don’t do that again mumu. My head almost exploded!
 
mumukada Wrote:
——————————————————-
> Your answer: B was incorrect. The correct answer
> was D) The path dependency of cash flows.
>
> Backward induction can’t effectively capture
> path-dependent cash flows. Backward induction can
> account for many prepayments, default risk, and
> variable interest rates.
>
>
>
> shit..the explanation doesn’t justify what i said
> in my previous post..
>
> basically I still don’t get it…
>
> i think they just MIS typed - I think the question
> is supposed to say which is the MOST likely reason
> why the lattice……blah blah
I would have gone for B also. It says least likely - we know backward induction (giggle every time I say this) does not account for prepayments/cash flows. I don’t get it either.
 
this seems pretty simple if you think about it this way… reg. option free corp bond CAN be priced w/ binomial right?? Well those have default risk so answer = B
 
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