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Monte Carlo methods in finance

From Wikipedia, the free encyclopedia.

In the field of financial mathematics, many problems, for instance the problem of finding the arbitrage-free value of a
particular derivative security, boil down to the computation of a particular integral. In many cases these integrals can be
valued analytically, and in still more cases they can be valued using numerical integration. However when the number of
dimensions (or degrees of freedom) in the problem is large, numerical integration methods become intractable. In these
cases it is common to resort to the more widely applicable Monte Carlo methods to solve the problem. For large
dimension integrals as can very often occur in financial problems, Monte Carlo methods converge to the solution more
quickly than numerical integration methods. The advantage Monte Carlo methods offer increases as the dimensions of the
problem increase.

This article discusses typically financial problems in which Monte Carlo methods are used. It also touches on the use of
so-called "pseudo-random" methods such as the use of Sobol sequences.

Contents
1 Monte Carlo methods
1.1 Sample paths for standard models
1.2 Greeks
1.3 Variance reduction
2 Quasi-random (low-discrepancy) methods
3 Notes
4 References
5 Further reading

Monte Carlo methods

Recall from the fundamental theorem of finance that the value of a derivative is equal to the discounted expected value of
the derivative payoff where the expectation is taken under the risk-neutral measure [1]. An expectation is, in the language
of pure mathematics, simply an integral with respect to the measure. Monte Carlo methods are ideally suited to evaluating
difficult integrals (see also Monte Carlo method).

Thus let us suppose that our risk-neutral probability space is and that we have a derivative H that depends on a set of
underlying instruments S_1,...,S_n. Then given a sample ω from the probability space the value of the derivative is
H(S1(ω),S2(ω),...,Sn(ω) = :H(ω). Today's value of the derivative is found by taking the expectation over all possible
samples and discounting at the risk-free rate. I.e. the derivative has value:

where P(0,T) is the discount factor corresponding to the risk-free rate at the final maturity date T years into the future.

Now suppose the integral is hard to compute. We can approximate the integral by generating sample paths and then taking
an average. Suppose we generate N samples then

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which is much easier to compute.

Sample paths for standard models

In finance underlying random variables (such as an underlying stock price) are usually assumed to follow a path that is a
function of a Brownian motion 2. For example in the standard Black-Scholes model, the stock price evolves as

dS = µ(t)Sdt + σ(t)SdWt.

To sample a path following this distribution from time 0 to T, we chop the time interval of M units of length δt, and
approximate the Brownian motion over the interval dt by a single normal variable of mean 0 and variance δt. This leads to
a sample path of

for each k between 1 and M. Here each εi is a draw from a standard normal distribution.

Let us suppose that a derivative H pays the average value of S between 0 and T then a sample path ω corresponds to a set
{ε1,...,εM} and

We obtain the Monte-Carlo value of this derivative by generating N lots of M normal variables, creating N sample paths
and so N values of H, and then taking the derivative. Commonly the derivative will depend on two or more (possibly
correlated) underlyings. The method here can be extended to generate sample paths of several variables, where the normal
variables building up the sample paths are appropriately correlated.

It follows from the Central Limit Theorem that quadrupling the number of sample paths approximately halves the error in
the simulated price (i.e. the error has order sqrt(N) convergence).

In practice Monte Carlo methods are used for European-style derivatives involving at least three variables (more direct
methods involving numerical integration can usually be used for those problems with only one or two underlyings. See
Monte Carlo option model.

Greeks

Estimates for the "Greeks" of an option i.e. the (mathematical) derivatives of option value with respect to input
parameters, can be obtained by numerical differentiation. This can be a time-consuming process (an entire monte carlo run
must be performed for each "bump" or small change in input parameters). Further taking numerical derivatives tends to
emphasize the error (or noise) in the monte carlo value - making it necessary to simulate with a large number of sample
paths. Practitioners regard these points as the key problem with using Monte Carlo methods.

Variance reduction

Square root convergence is slow, and so using the naive approach described above requires using a very large number of
sample paths (1 million, say, for a typical problem) in order to obtain an accurate result. This state of affairs can be
mitigated by variance reduction techniques. A simple technique is, for every sample path obtained, to take its antithetic
path - that is given a path {ε1,...,εM} to also take { − ε1,..., − εM}. Not only does this reduce the number of normal samples
to be taken to generate N paths, but also reduces the variance of the sample paths, improving the accuracy.

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Secondly it is also natural to use a control variate. Let us suppose that we wish to obtain the Monte Carlo value of a
derivative H, but know the value analytically of a similar derivative I. Then H* = (Value of H according to Monte Carlo)
+ (Value of I analytically) - (Value of I according to same Monte Carlo paths) is a better estimate.

Quasi-random (low-discrepancy) methods

Instead of generating sample paths randomly, it is possible to systematically (and in fact completely deterministically,
despite the "quasi-random" in the name) select points in a probability spaces so as to optimally "fill up" the space. The
selection of points is a low-discrepancy sequence such as a Sobol sequence. Taking averages of derivative payoffs at
points in a low-discrepancy sequence is often more efficient than taking averages of payoffs at random points.

Notes
1. Frequently it is more practical to take expectations under different measures, however these are still fundamentally
integrals, and so the same approach can be applied.
2. More general processes, such as Levy processes, are also sometimes used. These may also be simulated.

References
John C. Hull (2000). Options, futures and other derivatives (4th ed.). Prentice Hall. ISBN 0-13-015822-4.
Peter Jackel (2002). Monte Carlo methods in finance. John Wiley and Sons. ISBN 0-47-149741-X.

Further reading
Paul Glasserman (2003). Monte Carlo methods in financial engineering. Springer-Verlag. ISBN 0-38-700451-3.

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