Page 104 - FINAL CFA SLIDES DECEMBER 2018 DAY 3
P. 104

LOS 10.p: Explain Monte Carlo simulation and                    Session Unit 3:
   describe its applications and limitations, p.234                10. Common Probability Distributions



     Monte Carlo simulation repeatedly inputs into a probability function, one or more risk factors
     that affect security values, in order to generate a distribution of security values.



     Step 1: Specify the function and risk factorse.g.:


                 Price t-1 = starting price; Drift - normal growth rate -3%; Volatility - of stock prices over time; N =

                 total no. of days in the given period



     Step 2: Randomly generate resulting values for stock prices.




    Step 3: Value the call and put options for each pair of risk factor values.




    Step 4: After many iterations, calculate the mean option value and use that as your estimate

    of the option’s value.




     Limitations?              Fairly complex and will provide answers that are no better than the
                               assumptions about the distributions of the risk factors and the

                               pricing/valuation model that is used
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