Monte Carlo Simulations: Autumn 2 0 0 9

A U T U M N 2 0 0 9
MONTE CARLO SIMULATIONS
Numerical Methods in Finance (Implementing Market Models)

COMPUTATIONAL FINANCE
MSc
©Finbarr Murphy 2007
Lecture Objectives
 Hedge Sensitivities
 Multiple Stochastic Factors

MSc
Agenda
Page
1
Computing Hedge Sensitivities using 2
MC
2
Multiple Stochastic Factors 9
3
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3
Computing Hedge Sensitivities with MC
 By now, we know that Delta is the rate of change of

the option relative to the underlying asset price.
 From our Finite Difference lectures

∂C C ( S + ∆S ) − C ( S − ∆S )
delta = ∆ = ≈
∂S 2∆S
 In Monte Carlo Simulations, a better approach is to
take the discounted expectations approach
4
 For a standard european call, we can express delta

as
∂C ∂ − rT
delta = ∆ = =
∂S ∂S
(
e E [ ST − K ]1ST > K )
 where
( vT +σzT )
ST = Se
 and
1ST > K
 is the indicator function which equals one if ST>K or
zero otherwise
5
 This gives us;
∆=e − rT
[
Ee ( vT +σzT )
1ST > K ]
 Now, we can simulate this easily in MatLab
6
 euroMCDeltaCalc.m
7
 Gamma is given by
∂∆ ∂ C C ( S + ∆S ) − 2C ( S ) + C ( S − ∆S )
2
gamma = Γ = = 2 ≈
∂S ∂S ∆S 2
 We can’t (easily) differentiate delta
[
∆ = e − rT E e ( vT +σzT ) 1ST > K ]
 To give an analytical solution so we rely on finite
difference methods to calculate gamma using Monte
Carlo methods
8
 Gamma by finite difference:
∂∆ ∂ C delta( S + ∆S ) − delta( S − ∆S )
2
gamma = Γ = = 2 ≈
∂S ∂S 2∆S
9
Agenda
Page
1
Computing Hedge Sensitivities using 2
MC
2
Multiple Stochastic Factors 9
3
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10
Multiple Stochastic Factors with MC
 To now, we have assumed that the asset price

changes have been driven by one stochastic factor,
the Brownian motion in the GBM process
 MC is very effective when we price options on asset

prices that are assumed to be driven by two or more
stochastic factors.
 Typically, we want to simulate stock price

movements, volatility movements and interest rates
11
 We could also include any number of other factors

such as
 Macro-economic variables
 Correlation with broad based indices
 etc
 We will begin by considering a GBM as before with a

stochastic volatility
12

 Firstly, we should note that volatility moves in a
random manner but tends towards a mean value
 We therefore need to estimate

 The mean volatility value
 The rate at which the volatility moves around this mean value
 The volatility of the volatility
 We also need to consider the correlation between the

stock price movement and the volatility movement
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13

 Starting again with our familiar GBM, it is governed by
the Stochastic Differential Equation (SDE)
dS = Sµdt + σSdz S
 The variance† SDE is given by
(
dV = α V − V dt + ξ V dzV )
 Where
 V is the mean volatility

 ξ is the volatility of the variance
 α is the mean reversion rate
 Note that the wiener processes are different!
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14
† Remember, variance = σ

 5Y NASDAQ Volatility versus index value
V
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15

 The interest in volatility is directly related to several
of its basic characteristics. In particular implied
volatility is considered to be a gauge for uncertainty.
 It tends to grow during times of economic or political crises
and thus reflects the general sentiment of market participants.
 Another important statistical property is its trend to revert to
its historical mean. This means volatility ‘recovers’ from shocks
or spikes over time and reverts to its typical levels.
 In addition, implied volatility tends to be higher than realised
volatility. This reflects the general aversion of investors to

carry a short option position. Therefore, a risk premium has to
be paid to the investor in reward for selling volatility.
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16

 One of the most important characteristics of volatility
is its negative correlation with respective to the
underlying equity index.
 If the equity index rises, volatility tends to fall and vice versa.
 The negative correlation between an equity index and

its volatility assures that a volatility index derivative
is a cheap hedge for equity market exposure.
 In the hedged position, the gain in the volatility index
derivative covers the loss out of the equity exposure.

 By adding volatility as a hedge a portfolio is
diversified with a new asset class, generating excess
returns and lowering risk.
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17

 Using some statistical tools, we can estimate V, ξ and
α from historical data
 The movement in volatility is correlated with stock

price movements
 We can do this by sampling zS and zV from the standard

normal bivariate distribution with correlation ρ

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18

 We do this by letting zS = ε1, a draw from a standard
normal (univariate) distribution function and setting zV
as
zV = ρ ε1 + 1 − ρ ε 22
 Where ε2 is a second independent draw from a

standard normal (univariate) distribution function
 The subsequent MatLab code is fairly routine at this

stage
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19
 euroMCDoubleStochastic.m
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20

 Here is a plot of the average of 100 simulated
volatilities over 1000 time steps
 Notice the mean reversion characteristic

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21
Recommended Texts
 Required/Recommended
 Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 4
 Additional/Useful
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22

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A U T U M N 2 0 0 9

MONTE CARLO SIMULATIONS

Numerical Methods in Finance (Implementing Market Models)

 Multiple Stochastic Factors

Computing Hedge Sensitivities with MC

 By now, we know that Delta is the rate of change of

 From our Finite Difference lectures

Computing Hedge Sensitivities with MC

 For a standard european call, we can express delta

Computing Hedge Sensitivities with MC

 This gives us;

Computing Hedge Sensitivities with MC

Computing Hedge Sensitivities with MC

Computing Hedge Sensitivities with MC

 Gamma by finite difference:

Multiple Stochastic Factors with MC

 To now, we have assumed that the asset price

 MC is very effective when we price options on asset

 Typically, we want to simulate stock price

Multiple Stochastic Factors with MC

 We could also include any number of other factors

 We will begin by considering a GBM as before with a

Multiple Stochastic Factors with MC

 We therefore need to estimate

 We also need to consider the correlation between the

Multiple Stochastic Factors with MC

 V is the mean volatility

Multiple Stochastic Factors with MC

Multiple Stochastic Factors with MC

volatility. This reflects the general aversion of investors to

Multiple Stochastic Factors with MC

 The negative correlation between an equity index and

derivative covers the loss out of the equity exposure.

Multiple Stochastic Factors with MC

 The movement in volatility is correlated with stock

 We can do this by sampling zS and zV from the standard

normal bivariate distribution with correlation ρ

Multiple Stochastic Factors with MC

 Where ε2 is a second independent draw from a

 The subsequent MatLab code is fairly routine at this

Multiple Stochastic Factors with MC

Multiple Stochastic Factors with MC

 Notice the mean reversion characteristic

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