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CFA Level II
#1

Which of the following is least likely a reason why the lattice-based backward induction method cannot be used to value a MBS? A) Prepayments. B) Default risk. C) Variable interest rates. D) The path dependency of cash flows. Isn’t the question implying that three of the above choices ARE the reason why backward induction cannot be used to value an MBS??

#2

yes, that is correct. I think this is one of those stupid questions that I would mark on the exam, guess and come back to it if I have time.

#3

is it D?

#4

I will go with D here. Sounds reasonable. What’s the correct answer?

#5

D. If there is path dependency of cash flows you would be able to use the backward induction model. The other answers are reasons you can’t.

#6

What coincidence, I would have guessed D :stuck_out_tongue:

#7

This would be vs. a binomial model right?

#8

Path dependency of CFs is for me a reason why you cannot use the method…same with prepayments… I’ll go with C

#9

B

#10

wait… if there is path dependency I CANNOT use the backward induction right?? so why does everyone chose D. Seems like D IS a reason why the lattice based backward induction cannot be used to value a MBS

#11

I would go with B also.

#12

i like D here. lattice based models like binomial options models show path dependency of cash flows… i can’t see why that would be a reason you couldn’t use it. that’s what it is, that’s why you do use it, no?

#13

I for one have absolutely no recollection of the term “lattice based backward induction” from my Schweser readings (and I did well on all my fixed income Q bank tests). So I would have assumed that anything called backward induction will not work when there is path dependency. Path dependency in turn is a function of prepayments. So that leaves variable rates or default risk. I don’t remember any of those complicated valuation models really addressing credit risk per se. They were much more concerned with embedded optionality. So I would guess that B - Default Risk is the answer.

#14

ok ok …I think the confusion is whether we’re reading D as “path-dependent-cash-flows” or “interest-rate-path-dependent-cash-flows” If it’s the latter, then I guess that would be a reason NOT to use the backward induction model. If its the first one (as written in the question) - then that WOULD be a reason to use in the backward induction… Schweser’s answer: coming up…

#15

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

#16

B) Default Risk

#17

Does lattice-based backward induction method = binomial model?

#18

^^ yes pinkman

#19

Let me change the question and see what answer works. ************************************************************ Which of the following is least likely a reason why the lattice-based backward induction method CAN (mwvt9 change) be used to value a MBS? A) Prepayments. B) Default risk. C) Variable interest rates. D) The path dependency of cash flows. Answer should be D with this question…right?

#20

If it was Book 7, they probably meant: Which of the following is least likely a reason why the lattice-based backward induction method cannot not be used to value a MBS?