The Monte Carlo

Method!!!
By: Joe Casey

What is a Monte Carlo

Method?

The expression "Monte Carlo method" is actually very general.

Monte Carlo methods are based on the use of random numbers and probability
statistics to investigate problems.
You can find MC methods used in everything from economics to nuclear physics to
regulating the flow of traffic.

A Monte Carlo method is a way of solving complex problems through approximation

using many random numbers. They are very versatile, but are often slower and less
accurate than other available methods.

Why Use the Monte Carlo Method?

They tend to be used when it is

unfeasible or impossible to
compute an exact result with a
deterministic algorithm.
More broadly, Monte Carlo

methods are useful for modeling

events with significant uncertainty
in inputs, such as the calculation
of risk in business.
The advantage of Monte Carlo

methods over other techniques

increases as the sources of
uncertainty of the problem
increase.

Monte Carlo Methods are

particularly useful in the

valuation of options with
multiple sources of
uncertainty or with
complicated features which
would make them difficult to
value through a
straightforward Black-Scholes
style computation.
The technique is thus widely

used in valuing Exotic

options.

Overview!
There is no single Monte Carlo method.

Instead, the term describes a large and

widely-used class of approaches.

Essentially, the Monte Carlo method solves a

problem by directly simulating the
underlying (physical) process and then
calculating the (average) result of the
process.

Because of their reliance on repeated

computation of random or pseudorandom numbers, these methods are
most suited to calculation by a computer

However, these approaches tend to follow

a particular pattern:

1. Define a Domain of Possible inputs

2. Generate Inputs randomly from the
domain using a certain specified
probability distribution
3. Perform a deterministic computation
( this means that given a particular
input it will always produce the same
output ) using inputs
4. Aggregate the results of the individual
computations into a final result

In Most Basic Terms

1. Draw a random number
2. Process this random number in some way,
for example plug it into an equation
3. Repeat steps 1 and 2 a large number of
times
4. Analyze the cumulative results to find an
estimation for a non random value

A little bit of History

The term "Monte Carlo method" was coined in the 1940s by

physicists working on nuclear weapon projects in the Los

Alamos National Laboratory.
The physicists were investigating radiation shielding and the
distance that neutrons would likely travel through various
materials. Despite having most of the necessary data, the
problem could not be solved with analytical calculations.
John von Neumann and Stanislaw Ulam suggested that the
problem be solved by modeling the experiment on a
computer using chance.
The name is a reference to theMonte Carlo
CasinoinMonacowhere Stanislaw Ulam's uncle would borrow
money to gamble

A Simple Example of the

Monte Carlo Method

Monte Carlo
Calculation of Pi
We will use the unit
circle circumscribed
by a square
However, it is easier
to just use one
quadrant of the
circle. Sooooo.

Monte Carlo Calculation

of Pi

So lets pretend you are a horrible dart

player. The worst. Every throw is
completely random.

In other words,

Now, Imagine throwing darts at the unit

circle
Because your throws are completely
random, The number of darts that land
within the shaded unit circle is
proportional to the area of the circle

Continued Example

If you remember your geometry, it is easy to show:

If each dart thrown lands somewhere inside the square, the ratio of "hits"
(in the shaded area) to "throws" will be one-fourth the value of pi.

Last one about pi, I

swear!

If you actually tried this experiment,

you would soon realize that it takes a
very large number of throws to get a
decent value of pi...well over 1,000.
To make things easy on ourselves,
we can have computers generate
random numbers.

So, How?
If we say our circle's radius is 1.0, for
each throw we can generate two
random numbers, an x and a y
coordinate
we can then use (x,y) to calculate the
distance from the origin (0,0) using the
Pythagorean theorem.
If the distance from the origin is less
than or equal to 1.0, it is within the
shaded area and counts as a hit.
Do this thousands (or millions) of times
then average, and you will wind up with
an estimate of the value of pi. How
good it is depends on how many
iterations (throws) are done.

Monte Carlo Methods for

Pricing Options

Mostly used to calculate the value of

an option with multiple sources of
uncertainty or with complicated
features
In terms of theory, Monte Carlo
valuation relies on risk neutral
valuation. This just means that the
current value of all financial assets is
equal to the expected future payoff of
the asset discounted at the risk-free
rate.

Here is the pattern that is used:

1. Generate several thousand
possible (but random) price paths for
the underlying (or underlyings) via
simulation
2. Then calculate the associated
exercise value (aka the "payoff") of
the option for each path.

3. These payoffs are then averaged

4. Discounted to today.

This result is the value of the option

History of MC methods in Finance

Monte Carlo methods were first introduced to

finance in 1964 byDavid B. Hertzthrough his

article inHarvard Business Review
The Monte Carlo method was first suggested
as a way to price options in 1977 by Phelim
Boyle in his paper: Options: A Monte Carlo
Approach

Pricing the Call Option

with the Monte Carlo
Method
A European-style call option gives the right,

but not the obligation, to "call" for a stock at

a specified "strike" price Kat a specified time
T
If the stock priceat timeis such that
,
the option holder "exercises" and collects
from the seller of the option. If
, the
option expires worthless
In either case the seller of the option collects
a fee called the "premium" for entering into
the agreement.

Financial Derivatives
We want to predict the price on a stock at time T.
Black-scholes assumes a Brownian motion (random walk) to figure out what is

most likely to happen to the price of a stock after time T

To apply this to the Monte Carlo Method we will run many possible Brownian

walks of a stock over some period of time T

The method we will use is:

1. Perform many sample walks of the stock

2. Compute the value of the derivative for each sample walk
3. Average all the derivative values together to come up with an expected
value for the derivative

Summary
Monte Carlo methods can help solve

problems that are too complicated to solve

using equations, or problems for which no
equations exist
They are useful for problems which have lots
of uncertainty in inputs
They can also be used as an alternate way to
solve problems that have equation solutions.
Drawbacks: Monte Carlo methods are often
slower and less accurate than solutions via
equations.

Sources
http://demonstrations.wolfram.com/MonteCar

loValuationOfAnOption/
http://demonstrations.wolfram.com/MonteCarl
oEstimateForPi/
http://en.wikipedia.org/wiki/Monte_Carlo_met
hod
http://en.wikipedia.org/wiki/Monte_Carlo_met
hods_in_finance
http://www.chem.unl.edu/zeng/joy/mclab/mcin
tro.html
http://en.wikipedia.org/wiki/Random_walk
http://en.wikipedia.org/wiki/Monte_Carlo_met