Monte Carlo Simulation in Financial Engineering and Option Pricing

Abdullah S. AlShemaly CIS5930: Monte Carlo Methods

Department of Computer Science, Florida State University
asa11m@my.FSU.edu

May 2, 2013

Abstract This paper covers some of Monte Carlo methods (MCMs) application in options pricing of the Financial Engineering (FE). This paper focuses on a topic about MCMs application for options pricing. It starts with providing a historical and theoretical background about Monte Carlo Method, pricing options and its two types: Plain vanilla option pricing and exotic options. Next it covers Monte Carlo Simulation on Options Pricing compared with actual values generated by classical approach. This comparison took place between European Options, American Options, Asian Option Monte Carlo Simulation and Barrier Option Monte Carlo Simulation.

Acknowledgment
First of all, I hereby would like to acknowledge my academic adviser at Florida State University (FSU), Professor Michael Mascagni, for his patient tutorship, in-depth comment and invaluable Advice during my Masters degree program at FSU. Special thanks are passed to him, especially in teaching Monte Carlo Method class during spring 2013. It has been a great joy to take two courses under his teaching, guidance and encouragement. I would like to express my gratitude for his enlightening instruction and warm-hearted assistance, and unfailingly support.

Keywords Options pricing, Monte Carlo simulation, stochastic approximation, American options, European options, Asian options, Barrier options, and look back options. 1

Contents
1 Introduction 2 Background 2.1 History . . . . . . . . . . . . . . . 2.2 Options . . . . . . . . . . . . . . . 2.3 Option Types . . . . . . . . . . . . 2.3.1 Plain vanilla Option Pricing 2.3.2 Exotic Options . . . . . . . 3 3 3 3 4 4 5 8 8 9 10 10 11 12 13

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3 Monte Carlo Simulation on Options Pricing 3.1 European Options . . . . . . . . . . . . . . . . . 3.2 American Options . . . . . . . . . . . . . . . . . 3.2.1 Black-Scholes PDE . . . . . . . . . . . . . 3.2.2 Least Square Monte Carlo Method (LSM) 3.3 Asian Option Monte Carlo Simulation . . . . . . 3.4 Barrier Option Monte Carlo Simulation . . . . . 4 Conclusion

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Introduction

Monte Carlo methods (MCMs) are a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results to generate samples from a probability distribution. MCMs are useful for simulating systems and to model phenomena with signicant uncertainty in inputs, such as the calculation of risk in business. Having said that, one of these phenomena is Financial Engineering (FE) which is a multidisciplinary eld involving nancial theory, the methods of engineering, the tools of mathematics and the practice of programming. In FE, MCMs are used to calculate the value of an option with multiple sources of uncertainty or with complicated features to determine the options pricing. MCMs are highly suited to many option pricing problems especially for non-recombined price option trees or lattices to overcome existing diculties. This paper focuses on a topic about MCMs application for options pricing. This paper focuses on a topic about MCMs application for options pricing. Section II starts with providing a historical and theoretical background about Monte Carlo Method, pricing options and its two types: plain vanilla option pricing and exotic options. Section III covered Monte Carlo Simulation on European, Asian and Barrier options. These simulations show the capabilities of MCMs and compare the results to the related pricing options actual results. In the last section, summary and conclusion are provided.

Background

In this section, historical background/option, its types and some theoretical background are covered.

2.1

History

The term Monte Carlo method was coined by Stanislaw Ulam in the 1940s. Black and Scholes (1973) successfully derived the rst closed form solution for European options, under the assumption that the stock price follows a lognormal distribution. Merton (1973) provided the rst analytical formula for a down and out barrier call option. This was then further extended for all types of standard barriers by Reiner and Rubinstein (1991). Boyle (1977) rst introduced using Monte Carlo simulation to study option pricing, where the payo was simulated for vanilla options. Hull and White (1987), Johnson and Shanno (1987), Scott (1987), and Figlewski (1992) also used Monte Carlo simulation for analyzing options. This was further extended by introducing variance reduction techniques and Monte Carlo simulation was used for Asian options, Barrier options and American options. Boyle (1977) used antithetic variates and control variates approaches to price European call options. Antithetic variates method was also considered by Fishman and Huang (1983), Rubinstein, Samorodnitsky and Shaked (1985), Hull and White (1987), and Clewlow and Carverhill (1994). Kemna and Vorst (1990) applied the control variates method in pricing Asian options. Broadie and Glasserman (1996) estimated price derivatives in a simulation framework by using control variates. The method was also employed by Clewlow and Carverhill (1994) and Carverhill and Pang (1995) to value options on coupon bonds. Boyle, Broadie and Glasserman (1997) derived the conditional expectation estimator for the price of a barrier option. Ross and Shanthikumar applied the conditional expectation technique to barrier options. They also combined the conditional expectation and importance sampling estimators. The application of importance sampling in pricing barrier options was described by Boyle. Glasserman, Heidelberger and Shahabuddin (1999) applied the combination of importance sampling and stratied sampling in the Heath-Jarrow-Morton framework. Glasserman and Staum (2001) applied importance sampling in pricing barrier options.

2.2

Options

An option is a contract between a buyer and a seller that gives the buyer the rightbut not the obligationto buy or to sell the underlying asset at an agreed price at a later date. There are two basic kinds of options: the call option and the put option. A call option gives the buyer the right to buy the underlying asset while a put gives the buyer to sell. The agreed price in the contract is known as the strike (price) price; the date in the contract is known as the expiry date; the nonrefundable fee that makes the option rights is called the premium price. There are two main types of options based on certain properties. These types are vanilla

and exotic options. The exotic options also have many other types, such as Asian options, barrier options, or look back options.

2.3
2.3.1

Option Types
Plain vanilla Option Pricing

A vanilla option is a normal call or put option that has standardized terms and no special or unusual features. Examples of vanilla option pricing are European options and American options. Risk Neutral Pricing of a European Vanilla Option Risk neutral pricing works for a vanilla call or put option. This paper will not discuss risk neutral pricing in depth. Consider an equity price process S(t) that follows a Geometric Brownian Motion process, which is the underlying model of stock price evolution that we will be using. It is given by the following stochastic dierential equation: dS (t) = S (t)dt + S (t)dB (t) where S is the asset price, is the drift of the stock, is the volatility of the stock and B is a Brownian motion (or Wiener process). It can be thought of dB as being a normally distributed random variable with zero mean and variance dt. The price of a European vanilla option is given as the discounted expectation of the option pay-o of the nal spot price (at maturity T): erT E (f (S (T ))) This expectation is taken under the appropriate risk-neutral measure, which sets the drift equal to the risk-free rate r: dS (t) = rS (t)dt + S (t)dB (t) Using the risk-neutral pricing method above leads to an expression for the option price as follows: erT E (f (S (0)e(r 2
1 2

)T + T N (0,1)

))

The key to the Monte Carlo method is to make use of the law of large numbers in order to approximate the expectation. Thus the essence of the method is to compute many draws from the normal distribution f (S (0)e(r 2
1 2

)T + T z

In this case the value of f is the pay-o for a call or put. By averaging the sum of these pay-os and then taking the risk-free discount we obtain the approximate price for the option European options European option is an option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes at a discount to its comparable American option discussed later. This is because American options allow investors more opportunities to exercise the contract. Black and Scholes (1973) successfully derived the rst closed form solution for European options, under the assumption that the stock price follows a lognormal distribution. Option pricing in the Black-Scholes model One of the most appealing features of the Black-Scholes model is the existence of an analytical formula for the pricing of European call and put options. Given that the model parameters (essentially ) are known, the Black-Scholes price of a European call or put option is calculated as: P riceBS = St e(T t) N (d1 ) Ker(T t) N (d2 ) t where St denotes the spot price, K is the strike price, r the interest rate, the dividend yield, (T t) the time to maturity and is a binary operator equal to 1 for call options and 1 for put options. Further, we have that: 2 t log( S k ) + (r + 2 )(T t) d1 = T t d2 = d1 T t in which is the volatility of the spot price. 4

American Options For American options, these are typically more common than Europeans. An American option is like a European option except that the holder may exercise at any time between the start date and the expiry date. The exercise time can be represented as a stopping time; so that American options are an example of optimal stopping time problems. Without prescribed exercise time makes it much harder to evaluate these options. The holder of an American option is thus faced with the dilemma of deciding when, if at all, to exercise. If, at time t, the option is out-of-the-money then it is clearly best not to exercise. However, if the option is in-the-money it may be benecial to wait until a later time where the payo might be even bigger. Tilley was the rst person who attempt to apply simulation to American option pricing, using a bundling technique and a backward induction algorithm. His approach is a single pass algorithm, in that all simulations are carried out rst before the algorithm is applied. The chief components of options are the striking price and the expiration date. The dynamics of the underlying asset are generally described by a stochastic dierential equation, usually containing diusion processes and jump processes. Due to the complexity of these dynamics, the valuation and optimal exercise of American options remains one of the most challenging problems in derivatives nance, particularly when more than one factor aects the value of the option. The American options pay-o is given by, for an American call option: (S ) = maxt T (S ( ) K )+ And, for an American put option, by: (S ) = maxt T (K S ( ))+ where is the exercise time. 2.3.2 Exotic Options

The calls and puts that we have talked about so far are generically known as Plain Vanilla, meaning that they are standardized. Besides that, there are also highly specialized options. These options are known as exotic options. There are many types of exotic options such as Lookback option, and more are created all of the time. A Lookback option is one in which the payout is a function of both the terminal stock value and the maximum or minimum value the stock achieves during the life of the option. Fixed Lookback option payos are calculated using the optimal value (maximum for a call, minimum for a put), see below gure.

Figure 1: Lookback Option When modeling exotic options, one has to make a fundamental decision very early in the process: should you model the option in a continuous-time, Black-Scholes type of model, or in a binomial model. Generally 5

many exotic options are initially priced via a binomial model, and then at some point it is gured out a closed-form pricing model. Sometimes, it turns out that no closed form solution is ever found. Indeed, for certain highly path-dependent options, one cannot even work backwards in a lattice, instead one must use a Monte-Carlo method to value the option, covered in next section. This paper will focus on two types of exotics: Asian options and Barrier options (knock-in and knock-out). Asian Options The term Asian Option means an option where the payo to the option is a function of the average price of the underlying for some portion of the life of the option. There are actually many variants of Asian options available. These variants are: Average price call: max(0, Save K ) Average price put: max(0, K Save ) Average strike call: max(0, ST Save ) Average strike put: max(0, Save ST ) The method for calculating the average can vary. Usually it is the arithmetic average, but can be the geometric average. If arithmetic average, usually no closed form solution exists. Typically it will rely upon Monte Carlo procedures to determine the value. Also, the period of from which the average is taken can vary tremendously, for example the average can be taken daily over life of the option, or from specic days during the life of the option, or etc. Notice that frequently its not practical to use backwards pricing for an Asian option. To see this, consider that at each terminal node, you would have multiple averages, depending upon which path you followed to that node. You would have to evaluate the terminal conditions for each path available in the lattice. How many paths are there? 2T , so if you had a 20 time step lattice, you would have to evaluate 220 = 1, 048, 576 paths. This simply is not practical, its faster to use Monte Carlo to arrive at an approximate answer. They were originally used in 1987 when Bankers Trust Tokyo oce used them for pricing average options on crude oil contracts; and hence the name Asian option. There are some dierent types of Asian options: Continuous arithmetic average Asian call or put with ( (S ) = 1 T
0 T

)+ S (t)dt K or(S ) =

1 K T

)+ S (t)dt

Continuous geometric average Asian call or put with ( 1 (S ) = e T

T
0

log S (t)dt

)+

( 1 or(S ) = K e T

T
0

log S (t)dt

)+

Discrete arithmetic average Asian call or put with ( (S ) = 1 iT S( ) K m + 1 i=0 m

m

)+ or(S ) =

)+ m 1 iT K S( ) m + 1 i=0 m

Discrete geometric average Asian call or put with ( 1 m )+ ( )+ m iT 1 iT (S ) = e m+1 i=0 S ( m ) K or(S ) = K e m+1 i=0 S ( m )

barrier Options Barrier options are options that have a payout that is dependent not only on the terminal stock price, but also depend upon whether the stock attains some barrier during the life of the option. Two general kinds: Knock-in options and Knock-out options. Knock-in options is the option comes into being only if the stock reaches a given barrier during its life, see below gure. However, the Knock-out options is the option ceases to exist if the stock reaches a given barrier during the options life. For example, Down-and-out call, this is a call with strike K that ceases to exist if the asset price reaches the barrier level H , where S0 > H . Down-and-in call is call with strike K that comes into existence only if the stock price reaches the barrier level. Assume for a moment that you held two portfolios: Portfolio A: One call with strike K Portfolio B: One down and in call with strike K and barrier H. One down and out call with strike K and barrier H. At maturity there are two potential states of the world, lets compare the portfolio values in each both for the stock remained above the barrier at all times (state 1) and in The stock at some point touched the barrier (state 2). In state 1, A: max(0, ST K ). B: Down and In: 0 (never activated) or Down and out: max(0, ST K ). In state 2, A: max(0, ST K ). B: Down and In: max(0, ST K ) or Down and Out: 0 (died when stock touched barrier).

Figure 2: Barrier Option

The Black-Scholes Model One of the most appealing features of the Black-Scholes model is that it does not only provide analytical formulas for the pricing of vanilla options, but also for a range of exotic options. The price of a barrier option will depend on the regular Black-Scholes parameters S0 , K, r, , T, as well as on the barrier level, denoted by H . We consider down-barrier call options with H < K and up-barrier call options with H > K . All options considered are struck at the money, i.e. K = S0 . The prices of the barrier options can be calculated as ( U IBS = H S ) 2 { 2

( PBS

H2 ,K S

) PBS

H2 ,H S

+ (H K )erT (dBS (H, S ))

+CBS (S, H ) + (H K )erT (dBS (S, H ))

U OBS = CBS (S, K ) CBS (S, H ) (H K )erT (dBS (S, H )) ( ) 2 ) ( 2 ) } { ( 2 H 2 H H rT CBS , K CBS , H (H K )e (dBS (H, S )) S S S By denition, we have that DIBS + DOBS = U IBS + U OBS = CBS , i.e. that the sum of a knock-in call option and a knock-out call option with the same strike price and barrier will equal the price of a vanilla call option. To implement the Black-Scholes model, we need to estimate the volatility parameter . A common approach to nding the appropriate sigma is to observe the implied volatility surface and choose a volatility corresponding to the strike price and maturity in question. Pricing Financial Options by Flipping a Coin A discrete model for change in price of a stock over a time interval [0, T ] is, Sn+1 = Sn + Sn t + Sn n+1 t, S0 = s where Sn = Stn is the stock price at time tn = nt; n = 0, 1, . . . N 1; t = T /N ; is the annual growth rate of the stock, and is a measure of the stocks annual price volatility or tendency to uctuate. Highly volatile stocks have large values of . Each term in sequence 1 , 2 , . . . takes on the values of 1 or -1 depending on the outcome value of a coin tossing experiment - heads or tails respectively. In other words, n = 1, 2, . . . { 1 with probability = 1/2 n = 1 with probability = 1/2 By using a computational program, it is very easy to create a sequence of random number. With this sequence, the equation (1) can then be used to simulate a sample path or trajectory of stock prices, {s, S1 , S2 , . . . , SN }. It has been shown as a relatively accurate method of pricing options and very useful for options that depend on paths.

Monte Carlo Simulation on Options Pricing

Monte Carlo Option Price is a method often used in Mathematical nance to calculate the value of an option with multiple sources of uncertainties and random features, such as changing interest rates, stock prices or exchange rates, etc. Using any programming language makes it very easy to create a sequence of random number indicating the uncertainties. Monte Carlo methods often give better results, because they have proved to be valuable and exible computational tools to calculate the value of options with multiple sources of uncertainty or with complicated features. This section will proved an experimental comparison between using actual values and Monte Carlo methods and study the error dierence for two plain vanilla options: European and American, and two exotic options: Asian and barrier.

3.1

European Options

In this section the comparison between Monte Carlo Estimate and the Black-Schole model for European options. From the formula, below: Sn+1 = Sn + Sn t + Sn n+1 t, S0 = s The random terms, Sn n+1 t can be considered as disturbances that model uctuations in the stock price. After repeatedly simulating stock price trajectories, and computing appropriate averages, it is possible to obtain estimates of the price of a European call option. Thus, the option has a payo function, f (S ) = max(S K, 0) 8

Where S = S (T ) is the price of the underlying stock at the time T when the option expires. The above equation produces one possible option value at expiration and after computing this thousands of times in order to obtain a feel for the possible error in estimating the price. In order to estimate the price call of a call option using a Monte Carlo method, an ensemble { } (k) SN = S (k) (T ), k = 1, . . . M of M stock prices at expiration is generated using the following dierence equation (k) (k) (k ) (k) (k ) (k ) Sn+1 = Sn + rSn t + Sn n+1 t, S0 = s Option pricing theory requires that the average value of the payos are equal to the compounded total return (s), at rate r over the life of option. obtained by investing the option premium, C (s) for the option price, the present value of the average of the payos The Monte Carlo estimate C computed using rules of compound interest is { } M 1 (k) N C (s) = (1 + rt) f (SN ) M
k=1

In [2], an experiment was done comparing the exact Black-Scholes Formula with Monte Carlo estimator to price standard European options, see table below for this comparison. In this experiment, the following parameters are used: r = 0.06; = 0.2; K = $50; k = 1, . . . M (where T = N t); N = 200. The result was as follows:

The following equation as used to calculate the relative error: The results are:

M onteCarloEstimateBlackScholeM odle BlackScholeM odle

3.2

American Options

The primary methods for pricing American options are binomial trees and other lattice methods, such as nite dierence methods to solve the associated boundary value partial dierential equations (PDEs). Due to the complexity of the underlying dynamics, for real-world applications approximate numerical methods are employed, especially for American options, these include the valuation of options, and risk analysis. One of the most popular numerical techniques in option pricing is Monte Carlo simulation. The Monte Carlo approach simulates paths for asset prices. For the n-dimension problem, Monte Carlo methods could converge to the solution more quickly, require less memory and are easier to program. In contrast to simpler situations, simulation is not the better solution because it is very time-consuming and computationally intensive. Since the convergence rate of Monte Carlo methods is generally independent of the number of state variables, it is clear that they become viable as the underlying models (asset prices, volatility and interest rates) and derivative contracts themselves (dened on path-dependent functions or multiple assets) become more complicated. 9

One of reason is nite dierence and binomial techniques become impractical in situations where there are multiple factors, and because at any exercise time, the holder of an American option optimally compares the payo from immediate exercise with the expected payo from continuation, and then exercises if the immediate payo is higher. Thus the optimal exercise strategy is fundamentally determined by the conditional expectation of the payo from continuing to keep the option alive. 3.2.1 Black-Scholes PDE

This is the famous Black-Scholes partial dierential equation (PDE): V 1 2V V + 2 s2 2 + rS rV = 0 t 2 s S It is a relationship between V, S, t and certain partial derivatives of V . And we should note that the Black-Scholes equation does not contain the drift parameter . In other words, the value of an option is independent of how rapidly or slowly an asset grows. The only parameter from the stochastic dierential equation mentioned previously (dS = Sdt + SdX ) for the asset price that aects the option price is the volatility, . One condition for PDE is that it must be satised for any option on S whose value can be expressed as some smooth function V (S, t). The Monte Carlo method lends itself naturally to the evaluation of security prices represented as expectations. Generically, the approach consists of the following steps: Simulate sample paths of the underlying state variables (e.g., underlying asset prices and interest rates) over the relevant time horizon. Simulate these according to the risk-neutral measure. Evaluate the discounted cash ows of a security on each sample path, as determined by the structure of the security in question. Average the discounted cash ows over sample paths. However, a diculty occurs for Monte Carlo valuation of American options, Monte Carlo methods are required for options that depend on multiple underlying securities or that involve path dependent features. Since determination of the optimal exercise time depends on an average over future events, Monte Carlo simulation for an American option has a Monte Carlo on Monte Carlo feature that makes it computationally complex [14]. For the European option, the MC method works well because the value is determined only by the terminal stock price if one assumes a given starting point, time, constant interest rate and volatility. It is easy to see that Monte Carlo simulation must work in a forward fashion. However, for the American option, because of early exercise, in contrast to a partial dierential equation, we would also need to know the option value at the intermediate times between the simulation start time and the option expiry time. In Monte-Carlo this information is harder to obtain, therefore, even though it is simple and capable of handling multi-factor problems, once we have to solve a problem backwards, Monte Carlo simulation becomes hard to implement. In this section will talk about Least square Monte Carlo method and will show some result from previous studies. 3.2.2 Least Square Monte Carlo Method (LSM)

Longsta and Schwartz (2001) introduce the use of Monte Carlo simulation and least squares algorithm of Carriere to value American options since nothing more than simple least square is required. At each exercise time point, option holders compare the payo for immediate exercise with the expected payo for continuation. If the payo for immediate exercise is higher, then they exercise the options. Otherwise, they will leave the options alive. The expected payo for continuation is conditional on the information available at that time point. The key insight underlying this approach is that this conditional expectation can be estimated from the cross-sectional information in the simulation by using least squares. This makes this approach readily applicable in path-dependent and multifactor situations where traditional nite dierence techniques cannot be used. To nd out the conditional expectation function, we regress the realized payos from continuation on a set of basis functions in the underlying asset prices. The tted values are chosen as the expected continuation values. We simply compare these continuation values with the immediate exercise 10

values and make the optimal exercise decisions, and then we obtain a complete specication of the optimal exercise strategy along each path. We recursively use this algorithm and discount the optimal payos to time zero. That is the option price. Paper [13] illustrated LSM technique using a number of realistic examples on An American Put on a Single Asset, and American Puts on Multiple Underlying Assets. This illustration includes the valuation of an American put. Moreover it analyzed how the LSM method fares when the number of stochastic factors is increased. The analysis results suggest that the LSM is more suitable for problems in higher dimensions than other comparable Monte Carlo methods. In [14], it implemented a Brownian bridge construction for the paths in the LSM method. This implementation revealed that this can reduce or remove the high dimensionality diculty for quasi-Monte Carlo quadrature of path dependent securities. In addition, the Brownian bridge method shows that the memory requirements of the LSM method can be signicantly reduced. The potential diculty with correlations between the paths did not turn out to be much of a problem, perhaps because the true correlations are via the early exercise boundary which is deterministic. The author concluded that the LSM method with random or quasi-random sequences has been shown to work well on a good selection of examples, but it still needs to be validated for more complicated examples, such as American Asian options with the average taken over a moving window.

3.3

Asian Option Monte Carlo Simulation

Asian options are of particular importance practical option which has low trading volumes (e.g. crude oil), since price manipulation is inhibited. Hence, the pricing of such options becomes one of the most interesting elds. Since there are no known closed form analytical solutions to arithmetic average Asian options, many numerical methods are applied. This section deals with pricing of arithmetic average Asian options with the help of Monte Carlo methods. We also compare the results from these two methods. To get the price of an arithmetic average price option we have to use Monte Carlo techniques again. Here we choose arithmetic average price Asian call option as example. Firstly, we use the crude Monte Carlo method with 10000 simulated paths to price the Asian option. The algorithm is as following:

The experiment done in [7] shows the limit of the crude Monte Carlo method. As K increases, although the standard errors decrease, the simulations become less ecient for the reason that the estimates go down much faster than the corresponding standard errors. On the other hand, when the time step number gets larger, the standard error does not become smaller at all. In [7], it uses the control variate method in order to make the approximation more ecient. In fact, there are many possible control variate choices to use. They use the nature guess to use geometric average Asian call option which is given by, )+ ( 1 m iT V = erT e m+1 i=0 log S ( m ) K as the control variate, and it might be the best control variate it can be found. Besides, European call option given by, U = erT (S (T ) K )+ The experiments results concluded that an argument showing that the arithmetic average Asian call option has a value less than or equal to the corresponding European call. A big disadvantage of using Monte Carlo methods for path dependent options is the large number of calculations that are necessary to update the path dependent variables throughout the simulation. 11

3.4

Barrier Option Monte Carlo Simulation

The rst step in pricing barrier options using Monte Carlo methods is to simulate the sample paths of the underlying stock price. In vanilla options, there is really no need for path generation, only the price of the underlying asset at maturity is of concern. But barrier options are path-dependent optionsthe payo is determined by whether or not the price of the asset hits a certain barrier during the life of the option. Due to this path-dependency, simulation of the entire price evolution is necessary. To simulate a sample path, we have to choose a stochastic dierential equation describing the dynamics of the price. We consider the price of the underlying asset is described by a Geometric Brownian Motion to yield to the following equation: St = S0 et+ Discretize the time interval (0, T ) with a time step t, St+t = St et+
t t
0

dW ( )

Where N (0, 1) is a standard normal random variable? Based on the above equation, we can therefore generate sample paths for the asset price. In [3] an experiment was done on a down-and-out put option priced using Monte Carlo simulation compared with the accurate value, where Sb < S0 , Sb < K . Table below shows the result of this comparison. 12

The table below, gives the results of the crude Monte Carlo simulation for the down-and-out put option with the given parameters. This experiment compares price values with dierent initial spot prices and barrier levels. Three sample sizes are considered: n = 100, 1000, 10000.

This experiment result of crude Monte Carlo are close to the corresponding accurate option values obtained from the analytical formula. The gures demonstrate that Monte Carlo methods can be used for barrier option pricing. Also, it was obvious from the experiment that the value of the down-and-out put option decreases as S0 increases. The down-and-out put option increases in price value as Sb decreases. For a knock-out option, increasing the absolute dierence between the barrier level and the initial spot price has a positive eect on the option value. The probability of knocking out approaches to zero as the absolute dierence increases, and therefore making the value of the option converge to an ordinary vanilla put value. There are lots of sources of error in a simulation which cannot be eliminated. But one of the simplest ways to improve accuracy is to increase the number of simulations. From Table above displays that the standard Monte Carlo method benets greatly when the number of simulations increases. The price value obtained from Monte Carlo simulation approaches to the accurate value as the number of trials increases. The results show that the Monte Carlo simulation converges quickly. It can be concluded that Monte Carlo simulation gives very good estimates with close proximity to the values given by the analytical formula. The price value only changes slightly after n is larger than 1000. Also, the standard error decreases as the number of simulations increases.

Conclusion

This paper provided a historical and theoretical background about Monte Carlo Method, pricing options and its two types: Plain vanilla option pricing and exotic options. Also, Mote Carlo Simulation on Options Pricing compared with actual values generated by classical approach. This comparison took place between

13

European Options, American Options, Asian Option Monte Carlo Simulation and Barrier Option Monte Carlo Simulation. Although, Monte Carlo method is primarily used for pricing of several kinds of exotic options for which there is no formula or the formula is dicult. It is also good as a way to double check any implementation of option pricing. Although, there arent really any programs that simply do Monte Carlo approximations of options, Monte Carlo Option Price is still used to calculate the value of an option with multiple sources of uncertainties and random features by developing a program to make it very easy to create a sequence of random number indicating the uncertainties. Monte Carlo methods often give better results, because they have proved to be valuable and exible computational tools to calculate the value of options with multiple sources of uncertainty or with complicated features. Yet, Pricing American options still remain a questionable area, particularly when Monte Carlo techniques are used. This is due mainly to the exibility of this method when used to solve high dimensional problems.

References
1. A. Jasra and P. Moral. Sequential Monte Carlo Methods for Option Pricing. London, UK, 2010. 2. B. Lu. Monte Carlo simulations and option pricing. Pennsylvania State University, 2011. 3. B. Wang and L. Wang. Pricing Barrier Options using Monte Carlo Methods. UPPSALA Univeristy, Sweden. U.U.D.M. Project Report 2011:5. 4. D. L. McLeish. Monte Carlo Simulation and Finance. John Wiley & Sons, New Jersey, 2005. 5. F. Black and M. Scholes. The pricing of options and corporate liabilities. Journal of political Economy, 1973. 6. G. A. Holton. Monte Carlo Method. Value-at-Risk: Theory and Practice., riskglossary.com, 2013. 7. H. Zhang. Pricing Asian Options using Monte Carlo Methods. U.U.D.M. Project Report 2009:7. UPPSALA Univeristy, Sweden.

8. M. Abudy and S. Benninga. Valuing Employee Stock Options in Imperfect Markets. 2010 9. N. Westermark. Barrier Option Pricing. The Royal Institute of Technology, Sweden. 10. P. Boyle, M. Broadie and P. Glasserman. Monte Carlo methods for security pricing. Journal of Economic Dynamics and Control 21.8 (1997). 11. P. Glasserman. Monte Carlo methods in nancial engineering. Vol. 53. Springer, 2003. 12. P. Pellizzari, Ecient Monte Carlo Pricing of Basket Options. Department of Applied Mathematics, University of Venice, 1998. 13. Q. Jia. Pricing American Options using Monte Carlo Methods. UPPSALA Univeristy, Sweden. U.U.D.M. Project Report 2009:8. 14. R. Caisch and S Chaudhary. MONTE CARLO SIMULATION FOR AMERICAN OPTIONS. University of California, LA. 15. R. Stulz. Options on the minimum or the maximum of two risky assets. Analysis and applications. Journal of Financial Economics, 1982. 16. S. Benninga (2009, July 30). Pricing Options with Monte Carlo. TAUVOD Youtube, 2011 17. S. Benninga. Financial modeling. MIT press, 2000. 18. Wikipedia contributors. Monte Carlo Methods for option pricing. wikipedia.org, 2013. ...

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