® ®

Monte Carlo Simulations using

MATLAB

© The MathWorks, Inc.

Vincent Leclercq, Application engineer

Email : [email protected]
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Agenda

 Principles and uses cases for Monte Carlo methods

 Using MATLAB toolbox for Monte Carlo simulations

 Develop you own Monte Carlo engine

 A quick overview of Variance reduction technics

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An simple example 100

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 Compute the area of a lake

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 We shot N cannon balls

 n balls out of the “lake”

 N- n balls in the lake

 One gets

Area Square N N n
  Area Lake  * Area Square
Area Lake N n N

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Take outs
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 Results depends on :

 random number generation (Mersenne Twister)

 Number of simulations

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Typical uses cases of Monte carlo in

finance
 Derivatives pricing

 Risk

 Structurer

 Stochastic Asset Liability Management

 …

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General Principles

 Estimation technique based on the simulation of a great

number of random variables
1

 Let’s consider I   g ( x)dx

0

 This can be seen as the expectation  g (U ) , with U being

a uniform random variable on (0,1), ie U~(0,1)

 We can estimate tis expectation using an empiric mean

from random draws

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General Principles, continued

 We need to generate a sequence {Ui} of random samples,

which are independent (iid)
1 m
 Then we can compute the empiric mean: Î m   g (U i )
m i 1

 From the law of Great Numbers, one gets :

lim Î m  I
m
Var ( g (U i ))
 Variance : Var ( Î m ) 
m
 Confidence interval : using a Gaussian approximation

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Good points and drawbacks

 Good points

 Various application areas

 Few hypothesis
 Easy to develop

 Drawbacks

 Dependency to random number generator

 Big variability (accuracy)
 Computation time

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Why MATLAB ?
 Efficiency :

 1 000 000 paths in less than 1 s

 25 times fastest thanExcel

 State of the Art Algorithms

 Mersenne Twister
 Linear algebra

 Lots of statistical distributions supported (+ than 20)

 Easy deployment

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Agenda

 Principles and uses cases for Monte Carlo methods

 Using MATLAB toolbox for Monte Carlo simulations

 Develop you own Monte Carlo engine

 A quick overview of Variance reduction technics

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Which tools for Monte Carlo simulations ?

 MATLAB : Core linear algebra engine, matrix factorisation, …

 Statistics toolbox : Random numbers, copulas, …

 Financial toolbox :

 Portsim :” Monte Carlo simulation of correlated asset returns”

 GARCH Toolbox

 garchsim

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Financial toolbox : portsim

 On a time interval, performances are driven by the following

equation :
ds
 dt   dt
S
 Time basis must be consistent for input parameters (drift and
volatility)

 Annual time basis -> dt in years

 Daily time basis -> dt in days

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Demo 1:
Geometric brownian motion
Lognormality of equity prices

 Historical data input

 Drift and volatility

 Annually or Daily

 Simulate 10 000 paths on one year.

 Compare results

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Demo 2:
Use the previous paths to price aVanilla option

 Apply the option payoff

 Vanilla -> No path dependancy

 Compute the call price for different strikes

 Compute the confidence intervals

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GARCH Toolbox : garchsim

Stochastic Volatility

 Simulations of Auto Regressive models / GARCH

 “Perform Monte Carlo simulation of univariate returns, innovations,and conditional
volatilities”

 Fitting (Adjust the model, garchfit function) and Simulation

 Simulation , several possibilities:

 Use of historic data (bootstrapping)

 See Market Risk Using Bootstrapping and Filtered Historical Simulation

 Use of random variables

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Agenda

 Principles and uses cases for Monte Carlo methods

 Using MATLAB toolbox for Monte Carlo simulations

 Develop you own Monte Carlo engine

 A quick overview of Variance reduction technics

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What do I need for Monte Carlo ?

 A good random number generator

 Rand, randn -> several chocie possible for random number

generation
 Random (more than 20 distributions), copularnd -> Statistics toolbox

 Linear algebra functions:

 Cholesky factorization
 cumsum

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Process

 Generate Random numbers

 Directly from the statistical distribution

 Through a uniform law

 -> Allow the use of quasi random number generation

 Apply the model (volatility, …)

 Computation of the empiric mean

 Confidence interval estimation

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Demo
Correlated Equities Simulation

 Input :

 Time : NDays
 Number of different paths : NSimulation
 Number of Assets : 2, NAssets with correlation
 We know :
 Volatility
 Correlations

 Output :

 Matrice de NDays* NSimulation*NAssets

 Preserved Correlations

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Agenda

 Principles and uses cases for Monte Carlo methods

 Using MATLAB toolbox for Monte Carlo simulations

 Develop you own Monte Carlo engine

 A quick overview of Variance reduction technics

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Variance Reduction

 Why ?

 Slow Convergence of Monte Carlo pricing

 Need a great number of paths

 Solution :

 Use if various variance reduction methods

 Several possible methods

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Variance Reduction : Overview

 Antithetic Variables

 Efficient, easy to implement

 Efficiency depends of the option (ex : Butterfly)

 Control Variables

 Use of a variable correlated to the one we want to estimate

 Ex : Vanilla option Pricing

 We canuse the close formula (Hulll) in order to compute the variance and the
expected return of the underlying at maturity
 We need to estimate the covariance between our control variable (the
underlying) and the variable we want to estimate (option price)

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Variance Reduction Overview (2/3)

 Quasi Monte Carlo

 Use of low discrepancy sequences

 “quasi random” sequences

 Halton sequences, Sobol sequences, …

 Better Accuracy

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Variance Reduction Overview (3/3)

 Variance reduction using conditionning

 Principle:
Var(E[X]) < Var(E[X |Y])

 Example : As You Like It option,

 At time T1, one can exercise a put or call at time T2, with a given strike
 At time T1, one can use Black Scholes closed formula to compute the call and put
price -> Reduced Variance

 Other techniques :

 Importance sampling
 Stratified sampling

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Demonstration
Vanilla option pricing using Variance Reduction

 Several methodology used

 Antithetic Variables

 Quasi Monte Carlo (Halton / Sobol)

 Control Variable

 Results comparison

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Variance Reduction, Key takeouts

 Efficient, Generic method

 Confidence intervals

 Variance Reduction technics should be used wisely, depending on

the product to price

 Example : Antithetic for options Butterfly lead to an increase of the

variance

 Lots of research papers

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General Conclusion

 MATLAB allow users to quickly develop and test advanced Monte

Carlo simulation

 Very generic solution

 New : a complete framework Monte Carlo simulation of Stochastic

Differential Equations

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Bibliography used

 Paolo Brandimarte, Numerical Methods in finance and Economics, A

MATLAB ®-based introduction, Second Edition

 Several MATLAB examples

 Paul Glasserman, Monte Carlo Methods in Financial Engineering

 Quasi-Monte Carlo Simulation

 http://www.puc-rio.br/marco.ind/quasi_mc.html

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 Questions ?

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