kingstongal

Most models come up with different probability weighted paths from initiation to termination of the fixed income instrument. Simpler models ( e.g. spreadsheet models ) might assume two branches at each node. More complex models e.g. a Monte-Carlo simulation, chose a variety of paths at each node . Each path essentially choses a different interest rate at the next node. How these interst rates are determined is by assuming a changing volatility pattern over time.

Similarly prepayment can be assumed at different speeds and more sophisticated models may choose different prepayment speeds at different nodes , but simpler ones may choose one of several speeds.

The net result ( i.e. NPV ) can be adjusted to match the market price of the instrument . The model can then be used to value the instrument over its life