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Answer: d) Step 4: The actual term structure is used to determine real-world probabilities, which finally determine the security’s price
**Correct answer: D** Tuckman’s Monte Carlo procedure uses **risk-neutral paths**, not real-world probabilities, to price an MBS. Typical steps are: 1. Generate a **risk-neutral** path for short rates. 2. Use the mortgage/prepayment rule to generate cash flows along that path. 3. Discount the cash flows back to present value using the short rates. 4. Repeat over many paths and average the discounted values. 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.
Author: Manit Arora
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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
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