Structured Securities Simulations

Overview

Interest Rates

The first unknown that often needs to be fixed is the path of future interest rates. This is critical for variable rate assets, but is also useful for simulating pre-payments, and defaults.

A common way to model the path of future interest rates is based on the expectations hypothesis, which says that the current shape of the interest rate curve expresses the market expection of future rates.

If a modeler assumes the rational expectations hypothesis, she can take the current curve and use the implied forward rates as the rates that occur at each asset reset date.

An alternative to using the current curve is to simulate the curve going forward using a Monte Carlo framework. Each simulated scenario is modeled, and then some average or other aggregate of the structures performance is reported.