Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 65. Monte Carlo Simulation in Finance

DESSISLAVA A. PACHAMANOVA, PhD

Assistant 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 is 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.

Keywords: simulation, pricing, risk management, random number generation, variance reduction, antithetic variables, stratified sampling, importance sampling, low discrepancy sequences

This chapter is 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 ...