Encyclopedia of Financial Models III

Monte Carlo Simulation in Finance

DESSISLAVA A. PACHAMANOVA, PhD

Associate Professor of Operations Research, Babson College

Abstract: Monte Carlo simulation has become an essential tool for pricing and risk estimation in financial applications. It allows finance professionals to incorporate uncertainty in financial models, and to consider additional layers of complexity that are difficult to incorporate in analytical models. The main idea of Monte Carlo simulation is to represent the uncertainty in market variables through scenarios, and to evaluate parameters of interest that depend on these market variables in complex ways. The advantage of such an approach is that it can easily capture the dynamics of underlying processes and the otherwise complex effects of interactions among market variables. A substantial amount of research in recent years has been dedicated to making scenario generation more accurate and efficient, and a number of sophisticated computational techniques are now available to the financial modeler.

This entry provides an introduction to Monte Carlo simulation and its applications to finance, from financial derivative pricing to portfolio risk management. We begin with a discussion of the main ideas behind simulation and a listing of several important areas in finance where simulation techniques are widely used. We then discuss technical issues that are important for understanding the advantages and limitations of the Monte Carlo simulation technique, such ...