Corporate Valuation

Chapter 4Monte Carlo Valuation¹

4.1 INTRODUCING MONTE CARLO TECHNIQUES

In recent years, the importance and the power of mathematical and numerical computation have increased noticeably both among academia and among financial practitioners. Financial assets derive their values from contractual claims and contractual claims are in turn linked to the occurrence of future events. Future events, however, are highly uncertain in the real world. Therefore, the ability to predict and describe them accurately is crucial to estimate the value of a financial asset with reliability. Modern computers have strengthened our ability to forecast future events and to produce accurate estimates through the implementation of complex mathematical and numerical methods that could not be applied without the support of sophisticated technologies. Several financial fields, including risk analysis, stress testing, and equity security valuation, have greatly benefited from these advances. The Monte Carlo method, probably the most intuitive and the most widely used among these approaches, finds wide support both in the financial literature and in practical implementations that require the estimation of uncertain processes. This chapter begins with a brief introduction to the Monte Carlo model; it then describes its interaction with the conventional fundamental valuation approaches, listing the advantages that Monte Carlo offers over its alternatives and explaining what drawbacks it is able to solve. Finally, ...