Monte Carlo simulation and EVT

It is a method in which the probability of particular outcome is identified by running multiple trial run of the particular event which is called simulation for several times and analyzing it This method of analyzing a stock is known as Monte Carlo simulation method. It is a statistical technique that is being adopted in finance. It got its name as Monte Carlo as Monte Carlo is a city where gambling is played a lot because of huge number of Casinos present over there. The probability is widely used in random wining games like roulette, dice, and slot machines. Monte Carlo simulation method is mostly done with the help of computers. The main reason behind such situation is the complexity in this algorithm. Monte Carlo method uses simulations of various price fluctuations that are possible in the stocks and corresponding volatility associated with it. Using these simulations the probability that a stock can be sold at a particular price is determined. It was introduced by David B Hertz in the year 1964.

Application in finance,

• In finance most of the problem is an integral part of a smaller samples when it comes to macro economics. These can be analyzed manually using probability differential equations or numerical integration. In finance these complexity is more and cannot be calculated manually and Monte Carlo simulation method suits this very well and comes out with a solution for such complex problems.

• In case of situations with more than 4 variables most of the Black Scholes models does not suits in, whereas other methods of binomial option pricing faces many problem during execution in that case Monte Carlo method plays reliable solution for it.

Limitation of Monte Carlo method,

• Monte Carlo method cannot be used in American option technique. The practical implementation of this method in American option technique is impossible.

Monte Carlo technique is an advanced technique that is being used in options to determine the option price. It is widely used for its simplicity and accuracy.

Question:

• List out some limitations in Monte Carlo technique.
• Application of Monte Carlo technique.