Interest rate path dependent because, interest, corporate

AnalystAlan

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!

yodacaia

I get the picture. So you mean that that 1% drop will be of a bigger affect on ABS than bonds!

giants2010

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.