1

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Introduction to Monte Carlo Simulations in
Finance
Dr Philip Symes,
June 2006
2

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1. Introduction

MC simulation is a widely used statistical technique

A large number of possible scenarios are created based on

their likelihood of occurring

In this way, a the behaviour of a portfolio under different future

conditions can be studied

Useful for estimating future share prices

Useful for Europeanstyle derivatives and hedge parameters

More efficient than other methods when there are more than !
stochastic variables
3

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
2. General Principles

"tart with an underlying distribution that describes the

relevant possible scenarios

E#g# if a variable is stochastic, a normal distribution will

describe its possible values

"ample $trials% from this distribution to mimic possible

values of a parameter

Make a number $paths% from combinations of trials, e#g#

the path over a year from daily trials

Each path is a possible scenario, so a large number of

paths are needed

&he payoffs generated for each scenario can be used to

estimate the probable future value of the asset
4

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
3. Accuracy of Simulation

'umber of trials( the standard error on the

estimate is given by , so the )*+ confidence
limit is given by(

M is the number of trials

s is the standard deviation

"everal variance reduction methods can be

applied, e#g# antithetic variable technique
M
f
M

96 . 1 96 . 1
+ < <
M

,eneric multi
variate normal
distribution
5

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4. E.. Simulatin t!e "iener Process for S!are
Pricin 1

-iener process or discretetime geometric .rownian

motion is described by(

DS is the change in the share price, S, in a small time

interval Dt/

e is a value sampled from a standardised ,aussian/

m is the e0pected return per unit time/

s is the volatility of the share price/

G(m,s) is a normal distribution with parameters m 1 s

&he e0pected value of this return is

&he stochastic component is with variance

( ) t t G t t
S
S
+ =

,
t
t
t
2

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4. E.. Simulatin "iener Process for S!are
Pricin 2

If a share has an e0pected return of 23+ p#a# and a

volatility of !3+ p#a# then 43#2 and 43#!

5efine t as days, i#e# t43#33!67 w#r#t# 2 year

&herefore we have a normal distribution given by

-e can either sample values directly from this distribution,

or renormalise values from G83,29

&he share price, S, is reset for every trial

.y repeatedly sampling possible paths from G, the

probability distribution of the share price at any point in
time can be obtained
( ) ( ) 0105 . 0 , 10 74 . 2 ,
4
=

G t t G
S
S

7

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
#. European$style %eri&ati&es

:alue at t43 is for a derivative that pays off

f
T
at T, when the risk free rate is known with certainty

E is the e0pectation in a risk neutral world,

r is the average instantaneous risk between t43 and

t4T.

Use S as an underlying variable, e#g# share price

If there are several variables involved, then the

correlations must be taken into account

5iscount each sample payoff as it is generated ; this

could be different for each trial
( )
T
T r
f E e f

=
8

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
'. Summary

MC simulation is a widely used statistical simulation

technique in science and finance

A large number of scenarios are created based on their

likelihood of occurring

&hese scenarios are used to make estimates of the mean

8with uncertainty9 of a future value

In this way, a the behaviour of a portfolio under different

circumstances can be studied

<ne e0ample is to model stochastic behaviour as a normal

distribution to simulate the future value of shares