Monte Carlo method

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Monte Carlo methods in VaR analysis

In Value at Risk analysis, an alternative method for calculating the probability distribution (rather than using the Delta-normal method or the Historical simulation method).

Monte Carlo simulations consist of two steps:

First, a stochastic (random) process for financial variables is specified as well as process parameters.
Both historical data and appropriate judgement can be used for such parameters as risk and correlations.

Second, multiple fictitious price paths are simulated for all variables of interest. At each horizon considered, the portfolio is marked-to-market using full valuation.
A distribution of returns is eventually produced, from which a VaR figure can be measured.

Monte Carlo methods in other applications

More generally, Monte Carlo methods are the simulation of multiple fictitious outcomes, using a combination of historical and judgemental parameters and a randomised process.

The name originated from the famous Monte Carlo casino.

See also