Anybody knows what Interest path dependent exactly means? Example: The callable corporate bond should be valued with an OAS from a binomial model because it is interest rate path dependent. On the other hand, ABS home equity should use Monte Carlo OAS because its CF are interest rate path dependent. Thank you!
A half baked answer… when the impact of a change in interest rate depends on where interest rates have been in the past, that’s called interest rate path dependent. So, a 1% drop in interest rate has a different impact on assets if the interest rate has been rising the last few months from 3% to 5%. Here a drop of 1% is not too much of a problem, but if rates have been stable at around 4% and then drop 1%, that has a different and more profound effect.
I get the picture. So you mean that that 1% drop will be of a bigger affect on ABS than bonds!
yazena Wrote: ------------------------------------------------------- > I get the picture. So you mean that that 1% drop > will be of a bigger affect on ABS than bonds! I dunno.
“I get the picture. So you mean that that 1% drop will be of a bigger affect on ABS than bonds!” This statement has nothing to do with path dependence. However, the callable bond will probably be less sensitive to rate changes because of the embedded option.
If interest rate goes from 8 --> 8.2 --> 7 --> 7.5 --> 8 --> 7.8 --> 7 --> 8. Irrespective of the path (ups and downs ) at 7% the value of option free bond can be calculated. If it has an option, example, callable at par anytime with coupon 7.5%, then at 7% it would almost always be called, at least theoretically when you calculate the bonds value. So not much of path dependency you look at spot rates and arrive at the bonds value. In case of MBS, lets say the mortgages are at 7.5% and for the first time rates drop to 7, there probably will be a huge refinancing and prepayments, meaning heavy drop in bonds value. However, when the rate drops to 7 for second and third time there would not be such a heavy effect so bond value does not drop as much. This is path dependent. It is not just the rate that matters but path of the rates too. Actually ABS are not so much path dependent compared to MBS, because ABS prepayments can be controlled with debt repayment conditions.
it means that is the outstanding balance of the underlying likely to change with fluctuation in interest rate. for a mortgaged backed sec, the underlying balance does change with interest rates. prepayment and prepayment burnouts along with interest paths(interest rate from piror periods to current periods, and to future). for a autoloan, lets say, its balance does not change much due to interest paths because no one really refinance or prepay the loan that often, so this case is not interest path dependent.