LOS 6.b

Question 1

What is Monte Carlo simulation?

Answer 1

• A technique that repeatedly generates random values for risk factors affecting security values to create a distribution of possible outcomes.
• The analyst must specify the parameters (like mean, variance, skewness) of the probability distribution for each risk factor.

Question 2

What are the steps in the example of valuing an option with Monte Carlo simulation?

Answer 2

Specify probability distributions for stock prices and interest rates.

Randomly generate values for these factors.

Value the option for each set of values.

Calculate the mean option value after many simulations.

Question 3

Name four uses of Monte Carlo simulation in investment applications.

Answer 3

Value complex securities.

Simulate profits and losses from trading strategies.

Estimate Value at Risk (VaR) for portfolios.

Simulate pension fund assets and liabilities over time.