Explanation:
Correct answer: D
Tuckman’s Monte Carlo procedure uses risk-neutral paths, not real-world probabilities, to price an MBS.
Typical steps are:
Option D is incorrect because it says the actual term structure is used to determine real-world probabilities and then price the security. That is not the Monte Carlo pricing approach described by Tuckman.
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Q-55.3 Tuckman’s procedure for pricing a (path-dependent) mortgage backed security (MBS) includes EACH of the following steps EXCEPT FOR:
A
a) Step 1: Generate a random, risk-neutral evolution (path) of the short interest rate
B
b) Step 2: Use a scheduled mortgage & prepayment function to generate cash flows along the path
C
c) Step 3: Starting with final cash flow, discount back to the present value using the short rates
D
d) Step 4: The actual term structure is used to determine real-world probabilities, which finally determine the security’s price