Level 1 CFA® Exam:
Monte Carlo Simulation
Monte Carlo simulation is used to simulate complex processes whose results are hard to predict using analytical methods. This method is based on repeated trials in which you draw predefined parameters affecting, for example, the price of a security.
Before we start simulation it is necessary to determine the probability distributions for the parameters used in the simulation. Trials are repeated several thousand times and every single time a valuation is conducted. Finally, the expected value of the security is calculated.
Monte Carlo is used among other things to:
- Value securities, including complex derivatives and strategies that involve them.
- Simulate trading and investment strategies.
- Estimate Value at Risk (aka. VAR).
- Value assets with distributions other than normal.
However, there may be some limitations to this method because:
- Monte Carlo simulation is a complex and laborious process.
- The simulation results are only as good as the assumptions that you make.
Some people also argue that, as a statistical method, it doesn’t allow you to examine some problems as thoroughly as analytical methods do.