Importance of Monte Carlo Simulation

Monte Carlo Simulation, or simulation, plays a quite important role in finance with many applications. Assume that we intend to estimate Net Present Value (NPV) of a project. There are many uncertainties in the future, such as borrowing cost, price of our final products, raw materials, and so on. For just a few variables, we still could manage the task easily. However, if we face two dozen variables with uncertain future values, it is a headache to find a solution. Fortunately, Monte Carlo Simulation can be applied here. In Chapter 10, Options and Futures, we have learnt that the logic behind the Black-Scholes-Merton option models is the normality assumption for stock returns. Because of this, their closed-firm solution could be replicated by simulation. Another example is to randomly choose 50 stocks from 4,500 available stocks. Unlike vanilla options, such as the Black-Scholes-Merton model, there are no closed-form solutions for exotic options. Fortunately...