Monte Carlo Option Pricing

Option values are calculated using the Monte Carlo option pricing model. This is best used for options that include features that are quite complicated or have various levels of uncertainty. The Monte Carlo Option Pricing model has been around for decades and was actually started in the 1940s by Stanislaw Ulam. The Monte Carlo Option Pricing model was not applied for almost 40 years, however.

Historical Applications of Monte Carlo Option Pricing

Despite being coined in the 1940s and applied in the late 1970s it was not until the late 1990s that the Monte Carlo option pricing model was used to price Asian options. M. Broadie and P. Glasserman demonstrated this to the world and inspired others to use the Monte Carlo option pricing model and stretch its limitations.

Monte Carlo Option Pricing Today

Later, American options were priced with the Monte Carlo option pricing method as a result of a method developed by E.S. Schwartz and F.A. Longstaff. This development allowed traders and investors to use the Monte Carlo option pricing model on American options when before it had not been demonstrated as a great model to use for these types of options.

Monte Carlo Option Pricing Generalized

The technique used for Monte Carlo Option Pricing is to simulate thousands of potential price paths for the underlying option. These price paths are random, but possible. The payoff, known as the exercise value, is then calculated for each price path. The payoffs are then discounted and averaged using the Monte Carlo option pricing model until the current date, which in turn is the optionsÕ value for Òtoday.Ó

Monte Carlo Option Pricing Applied

The application of the Monte Carlo Option pricing model works well for options that canÕt be handled with the Black-Scholes model. The Black-Scholes model is great for straightforward options that donÕt have complicated features or various levels of uncertainty. For options that fit these descriptions the Monte Carlo Option Pricing model can be applied. Options that are most likely to fit these descriptions include real options analysis and Asian options. In general, however, Monte Carlo option pricing is slow so for quick responses this method is not usually recommended.

Monte Carlo Option Pricing Conclusion

Though the Monte Carlo Option Pricing model has been around for many decades only recently has it found a ÒhomeÓ with traders. Many traders have found that this particular model works well with Asian options and that is where it will be found most often. Other models like the Black and Scholes are too easy and fast for straightforward options to risk substituting this model instead.