If Cash flow are independent of past interest rate, OAS should be used with the binomial model.
what does it mean exactly by " independent of past interest rate"? does it mean there is no prepayment?
Please add some comments
Hi,
Thanks for the questions, certainly helps to clarify my understanding too.
Basically the question is, “is the periodic cash flow dependent on the interest rate path”?
If no: Use Binomial (e.g. Callable Corporate Bond)
Why: In callable corporate bond, recall that we are to draw the binomial tree for the prices of callable corporate bonds and compare them to the exercise price. At any particular node, if in-the-money, the option holder would exercise it, and we could determine resulting cash flow, which is the exercise price. We don’t need to know what is the interest rates prior to that node (i.e. the interest rate path), it is irrelavant, we say that the periodic cash flow is not dependent on the interest rate path.
If yes: Use Monte Carlo (e.g. CMO). In passthrough securities, e.g. CMOs, cash flows are affected by prepayments. Prepayments, in turn, is affected by prior interest rates. If the prior interest rates were low previously, there are prior opportunities to refinance. Since prior interest rate affect prepayment, and prepayment affects the periodic cash flow. We say that yes, periodic cash flow is dependent on the interest rate path.
Hope it helps! (see page 471 of vol 5 curriculum for details)