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Answer: c) The interest rate tree uses all possible paths
**Correct answer: The interest rate tree uses all possible paths** The main distinction is that an **interest rate tree** systematically lays out the set of possible future rate paths, while **Monte Carlo** simulates a large number of random paths. - Both methods can use a **term structure model**. - Both methods value the mortgage by **discounting cash flows using short rates**. - Monte Carlo **does** rely on probabilities through the simulated risk-neutral distribution. So the key difference is that the **tree explicitly represents all possible paths**, whereas Monte Carlo approximates the distribution by simulation.
Author: Manit Arora
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Q-55.4 What is the key DIFFERENCE between using an interest rate tree and a Monte Carlo simulation to price a mortgage pass-through?
A
a) The interest rate tree uses a term structure model
B
b) Security is priced by discounting cash flows using the short rates
C
c) The interest rate tree uses all possible paths
D
d) Monte Carlo does not make use probabilities since each trial is a single path
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