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Capital Market Risk Advisors

CMRA

Monte Carlo Simulation

Monte Carlo is most helpful when some or all assets in a

portfolio are not amenable to analytical treatment

future price scenarios

2 Portfolio valuation - for each scenario, compute a

portfolio value

3 Summary - report the results of the simulation, either

as a portfolio distribution or as a particular risk

measure

CMRA 2

Monte Carlo Simulation

Scenario generation

Monte Carlo begins with the generation of n normal

variables with unit variance and correlation matrix Σ.

factorization, yielding Σ=ATA

variables

with the correlation matrix

CMRA 3

Monte Carlo Simulation

Cholesky Decomposition

we find A?

0 a a

s s s = a a

21 22 23 21 22 0 22 32

s31 s32 s33 a31 a32 a33 0 0 a33

2

a11a21 a11a31

s =

21 22 23 11 21 21 22

s s a a a2

+ a 2

a a

21 31 + a32 22

a

s31 s32 s33 a a a a + a a a2 + a2 + a2

11 31 21 31 32 22 31 32 33

CMRA 4

General Result

1/ 2

i−1

2

aii = sii −∑aik

k=1

i−1

1

aij = (sij −∑aikajk )1/ 2 j = i +1, i + 2,, N

aii k=1

CMRA 5

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