In Chapter 9, we discussed one model that is used to value callable agency debentures and corporate bonds, the binomial model. This valuation model accommodates securities in which the decision to exercise a call option is not dependent on how interest rates evolved over time. That is, the decision of an issuer to call a bond will depend on the level of the rate at which the issue can be refunded relative to the issue’s coupon rate, and not the path interest rates took to get to that rate. In contrast, there are fixed income securities and derivative instruments for which the periodic cash flows are “interest rate path-dependent.” This means that the cash flow received in one period is determined not only by the current interest rate level....