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Monte Carlo Simulation

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Monte Carlo Simulation
A method of determining the value of a Derivative by simulating the evolution of the Underlying variable(s) many times over. The discounted average outcome of the simulation gives an approximation of the Derivative’s value. This method may be used to value complex derivatives, particularly path-dependent options, for which closed-form solutions have not been or cannot be found. Monte Carlo simulation can also be used to estimate the Value-at-risk (VAR) of a Portfolio. In this case, a simulation of many correlated market movements is generated for the markets to which the Portfolio is exposed, and the positions in the Portfolio revalued repeatedly in accordance with the simulated scenarios. The result of this calculation Will be a probability Distribution of Portfolio gains and losses from which the VAR can be determined. The principal difficulty with Monte Carlo VAR analysis is that it can be very computationally intensive.
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