P1.T2.

Quantitative Analysis
Bionic Turtle FRM Practice Questions
Jorion, Value-at-Risk:The New Benchmark for
Managing Financial Risk, Chapter 12: Monte Carlo
Methods

P1.T2. QUANTITATIVE ANALYSIS.........................................................................................................1

BIONIC TURTLE FRM PRACTICE QUESTIONS ........................................................................................1
JORION, VALUE-AT-RISK:THE NEW BENCHMARK FOR MANAGING FINANCIAL RISK, CHAPTER 12:
MONTE CARLO METHODS ..................................................................................................................1
P1.T2.97. GEOMETRIC BROWNIAN MOTION (GBM) MONTE CARLO .................................................................... 4
AIM: Describe how to simulate a price path using a geometric Brownian motion model. .................. 4
P1.T2.98. INVERSE TRANSFORM METHOD ........................................................................................................ 6
AIM: Describe how to simulate various distributions using the inverse transform method. ............... 6
P1.T2.99. BOOTSTRAP METHOD ..................................................................................................................... 8
AIM: Describe the bootstrap method. .................................................................................................. 8
P1.T2.100. OPTION SIMULATIONS (MCS) ..................................................................................................... 10
AIM: Explain how simulations can be used for computing VaR and pricing options. ........................ 10
P1.T2.101. MONTE CARLO SIMULATION ACCURACY ........................................................................................ 12
AIM: Describe relationship between number of replications and standard error of the estimated
values; identify acceleration techniques. ........................................................................................... 12
P1.T2.102. CHOLESKY AND MONTE CARLO .................................................................................................... 16
AIMS: Explain how to simulate correlated random variables using Cholesky factorization. Describe
deterministic simulations. Discuss the drawbacks and limitations of simulation procedures. .......... 16
P1.T2.127. GEOMETRIC BROWNIAN MOTION (GBM) MODEL ........................................................................... 19
AIM: Describe how to simulate a price path using a geometric Brownian motion model. ................ 19
P1.T2.128. SIMULATION WITH INVERSE TRANSFORM METHOD .......................................................................... 21
AIM: Describe how to simulate various distributions using the inverse transform method. ............. 21
P1.T2.129. BOOSTRAP VAR ........................................................................................................................ 24
AIM: Describe the bootstrap method. ................................................................................................ 24
P1.T2.130. MCS OF VAR ........................................................................................................................... 26
AIM: Explain how simulations can be used for computing VaR and pricing options. ........................ 26
P1.T2.131. STANDARD ERROR IN MONTE CARLO SIMULATION .......................................................................... 29
AIM: Describe the relationship between the number of Monte Carlo replications and the standard
error of the estimated values. ............................................................................................................ 29
P1.T2.132. MONTE CARLO SIMULATION ACCELERATION .................................................................................. 32
AIM: Describe and identify simulation acceleration techniques. ....................................................... 32
P1.T2.133. CHOLESKY FACTORIZATION .......................................................................................................... 34
AIM: Explain how to simulate correlated random variables using Cholesky factorization. ............... 34

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Jorion, Value-at-Risk:The New Benchmark for Managing Financial

Risk, Chapter 12: Monte Carlo Methods
Learning Outcomes:
P1.T2.97. Geometric Brownian motion (GBM) Monte Carlo
P1.T2.98. Inverse transform method
P1.T2.99. Bootstrap method
P1.T2.100. Option simulations (MCS)
P1.T2.101. Monte Carlo simulation accuracy
P1.T2.102. Cholesky and Monte Carlo
P1.T2.127. geometric Brownian motion (GBM) model
P1.T2.128. Simulation with inverse transform method
P1.T2.129. Boostrap VaR
P1.T2.130. MCS of VaR
P1.T2.131. Standard error in Monte Carlo simulation
P1.T2.132. Monte Carlo simulation acceleration
P1.T2.133. Cholesky factorization

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P1.T2.97. Geometric Brownian motion (GBM) Monte Carlo

AIM: Describe how to simulate a price path using a geometric

Brownian motion model.
Questions:
97.1 For a geometric Brownian motion (GBM) Monte Carlo simulation (MCS), the random
standard normal variable (y) is generated per inverse transform method: x = CDF N(y) such that
y = inverse CDF N^(-1)(x), where (x) is a uniform random number that falls between 0 and 1
exclusive [0,1]. For example, if x = 0.5, then y = N^(-1)(0.5) = 0. In this case the inverse of the
standard normal cumulative distribution is zero as the x = CDF N(y) = N(0) = 0.5.
Assume the initial stock price (S0) is $10.00 and each step in the simulation is one day. The
expected annual return on the stock is 12% with annual volatility of 30%. Finally, the first
uniform random number [0,1] is 0.95. What is the simulated stock price at the first step (S1),
assuming 250 trading days per year?
a)
b)
c)
d)

$10.12
$10.22
$10.32
$10.42

97.2 Assuming the correct S(1) simulated price above, if the next random uniform variable [0,1]
is 0.01, then what is the day two (S2) simulated price?
a)
b)
c)
d)

$9.87
$9.97
$10.07
$10.17

97.3 Which of the following best describes the GMB MCS?

a)
b)
c)
d)

Stochastic drift (scaling with time) plus deterministic shock (volatility scaling with
square root of time)
Stochastic drift (scaling with square root of time) plus deterministic shock (volatility
scaling with time)
Deterministic drift (scaling with time) plus stochastic shock (volatility scaling with
square root of time)
Deterministic drift (scaling with square root of time) plus stochastic shock (volatility
scaling with time)

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Answers:
97.1 C. $10.32
Per finite GBM, the change in (S) is given by S(0)*[drift*interval + random normal
deviate*volatility*SQRT(interval)].
In this case, the simulated (S1) stock price is given by:
10 + 10 * (12%*1/250 + 1.645*30%*SQRT(1/250)) = $10.316
Note 1: N^(-1)(0.95) = 1.645, which you must know without a lookup.
Note 2: the drift is only 12%/250. Without the drift, the S(1) is $10.31 instead of $10.32
97.2 A. $9.87
10.32 + 10.32 * (12%*1/250 + -2.33*30%*SQRT(1/250)) = $9.868
97.3 C.
Deterministic drift (scaling with time) plus stochastic shock (volatility scaling with square root of
time)
Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t2-97-geometricbrownian-motion-gbm-monte-carlo-simulation.3901/

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