ACTS 4302

Instructor: Natalia A. Humphreys

SOLUTION TO HOMEWORK 9
Lesson 15: Monte Carlo Valuation.
Sufficient work must be shown to get credit for a correct answer. Partial credit may be given for
incorrect answers which have some positive work.
Problem 1
For a stock, you are given:
(i) The stocks prices follow a lognormal model.
(ii) Current stock price is $100.
(iii) The stocks continuously compounded rate of return is 0.15.
(iv) The stocks annual volatility is 0.3.
(v) The stock pays no dividends.
(vi) The continuously compounded risk-free interest rate is 0.05.
The stocks price at the end of 2 years is simulated using the following uniform [0, 1) random numbers:
0.3821

0.6844

0.4562

0.0749

0.9265

Using these numbers and the inversion method to perform five trials, one number per trial, calculate
the expected stock price at the end of 2 years.
(A) 110.17

(B) 116.19

(C) 134.56

(D) 153.97

(E) 173.15

Key: C
Solution. The parameters of the lognormal model are

m = t = ( 0.5 2 )t = (0.15 0.5 0.32 )2 = 0.105 2 = 0.21; v = t = 0.3 2 = 0.4243

The following table contains generation of lognormal random numbers from given uniform [0, 1) random
numbers ui s:
ui

zi = N 1 (ui )

0.3821

-0.30

0.0827

1.0863

0.6844

0.48

0.4137

1.5123

0.4562

-0.07

0.1633

1.1774

0.0749

-1.44

-0.4010

0.6696

0.9265

1.45

0.8253

2.2825

ni = m + vzi = xi = eni
= 0.21 + 0.4243zi

Thus, the average projected price is:

5

S(2) = S(0)

1X
1
xi = 100 (1.0863 + 1.5123 + 1.1774 + 0.6696 + 2.2825) =
5
5
i=1

= 100 1.3456 = 134.5629 134.56 C

Problem 2
For a stock, you are given:
(i) The stocks prices follow a lognormal model.

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

(ii) The stocks current price is 56.12.

(iii) The stocks continuously compounded rate of return is 0.15.
(iv) The stocks annual volatility is 0.25.
(v) The stock pays no dividends.
(vi) The continuously compounded risk-free interest rate is 0.04.
A 3-month European call option on the stock has strike price 61.
Simulate the stocks price using the following numbers drawn from a standard normal distribution:
0.48

0.93

0.57

1.39

Using these numbers, one number per simulation, calculate the expected option payoff.
Solution. Since we want the undiscounted payoff, we dont use risk-neutral probabilities. We use
= 0.15, not r = 0.05. The parameters of the lognormal model are

m = t = ( 0.5 2 )t = (0.15 0.5 0.252 )0.25 = 0.0297; v = t = 0.25 0.25 = 0.1250

The following table contains generation of lognormal random numbers from given standard normal
random numbers zi s:
zi = N 1 (ui )

ni = m + vzi =
xi = eni
= 0.0297 + 0.1250zi

Si = 56.12xi max(0, Si 61)

0.48

0.0897

1.0938

61.3859

0.3859

0.93

0.1459

1.1571

64.9378

3.9378

-0.57

-0.0416

0.9593

53.8353

-1.39

-0.1441

0.8658

48.5906

Thus, the average payoff is:

1
(0.3859 + 3.9378) = 1.0809
4

Problem 3
For a stock, you are given:
(i) The stocks prices follow a lognormal model.
(ii) The stocks current price is 95.
(iii) The stocks continuously compounded rate of return is = 0.15.
(iv) The stocks annual volatility is 0.25.
(v) The stock pays quarterly dividends of 3. The next dividend will be paid 3 months from now.
(vi) The continuously compounded risk-free interest rate is 0.05.
A 1-year European call option on the stock has strike price 82. The payoff on the option will be based
on the ex-dividend price.
Simulate the stocks price using the following standard normal random numbers in the order given to
simulate the change in price for each quarter.
1.5

1.9

0.2

0.6

Calculate the simulated present value of the option in this run.

Solution. First we calculate the quarterly price multipliers. Since we want a present value of an option
we dont use true probabilities. We use r = 0.05, not = 0.15. The parameters of the lognormal model
are

m = t = (r 0.5 2 )t = (0.05 0.5 0.22 )0.25 = 0.0047; v = t = 0.2 0.25 = 0.1250

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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

The stock price is calculated recursively, multiplying the previous price by the multiplier and subtracting
the dividend.
The following table contains generation of lognormal random numbers from given standard normal
random numbers zi s:

zi = N 1 (ui )

ni = m + vzi =
xi = eni
= 0.0047 + 0.1250zi

S0.25t = S0.25(t1) xi 3

-1.5

-0.1828

0.8329

76.1278

1.9

0.2422

1.2740

93.9893

0.2

0.0297

1.0301

93.8215

-0.6

-0.0703

0.9321

84.4512

Thus, the value of the call option is:

e0.05 (84.4512 82) = 2.3317

Problem 4
The current exchange rate between dollars and pounds is $1.30/. You are given:
(i)
(ii)
(iii)
(iv)

The
The
The
The

exchange rate follows the Black-Scholes framework.

continuously compounded risk-free rate in dollars is 4%.
continuously compounded risk-free rate in pounds is 2%.
volatility of the exchange rate is 0.2.

A 3-month dollar-denominated European call option on pounds has a strike price of $1.25/. The value
of this option is estimated using simulation. One random number is used for each trial.
You are given the following standard normal random numbers to be used for the simulation:
0.35

0.74

0.25

1.72

Determine the resulting price for the option.

Solution. Since we want a present value of an option we dont use true probabilities. We use r = r$ =
0.04, and = r = 0.02. The parameters of the lognormal model are

m = t = (r 0.5 2 )t = (0.04 0.02 0.5 0.22 )0.25 = 0; v = t = 0.2 0.25 = 0.1

The following table contains generation of lognormal random numbers from given standard normal
random numbers zi s:

zi = N 1 (ui ) ni = m + vzi = xi = eni

= 0.1zi

Si = 1.3xi Payoff=Si 1.25

0.3500

0.0350

1.0356

1.3463

0.0963

0.7400

0.0740

1.0768

1.3998

0.1498

-0.2500

-0.0250

0.9753

1.2679

0.0179

1.7200

0.1720

1.1877

1.5440

0.2940
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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

Thus, the value of the call option is:

1
e0.040.25 (0.0963 + 0.1498 + 0.0179 + 0.2940) = 0.99 0.1395 = 0.1381
4

Problem 5
For a stock, you are given:
(i) The stocks prices follow a lognormal model.
(ii) The stocks current price is 37.60.
(iii) The stocks continuously compounded rate of return is = 0.25.
(iv) The stocks annual volatility is 0.35.
(v) The stock pays no dividends.
(vi) The continuously compounded risk-free interest rate is 0.05.
Simulate the stocks price for 6 months using the following standard normal random numbers in the
order given to simulate the change in price for each month.
1.3

1.7

0.4

0.3

0.6

Calculate the simulated present value of a 6-month Asian arithmetic average strike call option on the
stock.
Solution. First we calculate the monthly price multipliers. Since we want a present value of an option
we dont use true probabilities. We use r = 0.05, not = 0.15. The parameters of the lognormal model
are
r

1
2
2 1
= 0.1010
m = t = (r 0.5 )t = (0.05 0.5 0.35 ) = 0.0009; v = t = 0.35
12
12
The stock price is calculated recursively starting with 45.50 and calculating each months price as the
previous months price times the multiplier.
The following table contains generation of lognormal random numbers from given standard normal
random numbers zi s:
zi = N 1 (ui )

ni = m + vzi =
xi = eni
= 0.0009 + 0.1010zi

Si = Si1 xi

-1.3000

-0.1323

0.8761

32.9410

1.7000

0.1708

1.1863

39.0774

0.0000

-0.0009

0.9991

39.0408

-0.4000

-0.0414

0.9595

37.4593

0.3000

0.0294

1.0298

38.5759

0.6000

0.0597

1.0615

40.9484

The strike price, the average of the stock prices for 6 months, is
32.9410 + 39.0774 + 39.0408 + 37.4593 + 38.5759 + 40.9484
= 38.0071
6
Thus, the value of the call option is:
e0.050.5 (40.9484 38.0071) = 2.8686

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ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

Problem 6
You simulate option A. To lower the variance of the estimate, you simulate option B, which is highly
correlated with option A and for which you have an exact value, using the same random numbers, and
use the control variate method.
The results of the trials are:
Trial Value of option A Value of option B
1

1.57

1.88

3.07

2.19

4.82

1.07

2.95

2.32

3.82

3.74

The exact value for option B is 2.62.

Determine the simulated value of option A.
(A) 1.61

(B) 2.24

(C) 2.87

(D) 3.25

(E) 3.63

Key: E
Solution. For the control variate method,

A = A + E[B] B

The means of the simulated values are:

16.23
= 11.2 = 2.24
A =
= 3.246, B
5
5
Therefore, the simulated result is
A = 3.246 + 2.62 2.24 = 3.626 3.63

Problem 7
A variable X is simulated. A control variate Y is used to make the simulation more efficient. After 100
trials, 100 random values xi for X and yi for Y are generated. You are given:
(i)
100
X
xi = 91.88
i=1

(ii)
100
X

yi = 91.34

i=1

(iii)
100
X

x2i = 87.15

i=1

(iv)
100
X

yi2 = 85.55

i=1
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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

(v)
100
X

xi yi = 86.24

i=1

Let s21 be the variance of the naive Monte Carlo estimate of X and s22 the variance of the control variate
estimate of Y .
Calculate the proportional reduction in variance from using the control variate method,
1 s22 /s21
(A) 11.58

(B) 2.47

(C) 0.08

(D) 0.92

(E) 1.00

Key: D
Solution. The variance of the naive Monte Carlo estimate of X is


1 100 87.15
1
2
= 0.000276
s21 =

91.88
100 99
100
1002
The variance of the control variate estimate of X is
+ V ar(Y ) 2Cov(X,
Y )
s22 = V ar(X ) = V ar(X)
is calculated above.
V ar(X)


1 100 85.55
1
2

V ar(Y ) =

91.34 = 0.000214
100 99
100
1002


1 100 86.24

Cov(X, Y ) =

0.9188 0.9134 = 0.000234

100 99
100
Hence,
s22 = 0.000276 + 0.000214 2 0.000234 = 0.000022
And the reduction in variance is
0.000022
1 s22 /s21 = 1
= 0.920501 0.92 
0.000276
Problem 8
You simulate a 3-month Asian arithmetic average price put option. To reduce the variance of the
estimate, you use the control variate method, with a 3-month Asian geometric average price put option
as the control variable. You are given:
(i) The stock price is 40.
(ii) The stock pays no dividends.
(iii) The strike price is 39.5.
(iv) The continuously compounded risk-free interest rate is 0.03.
(v) The average price is based on an average of 3 monthly prices.
(vi) The stocks annual volatility is 0.15.
(vii) The exact value of the geometric option is 0.642
Use the following random numbers from the standard normal distribution to perform one trial:
1.25

0.64

0.8

Determine the resulting simulated price for the arithmetic option.

(A) 0.571

(B) 0.638

(C) 0.982

(D) 1.211

(E) 1.785

Key: B
Solution. For the control variate method,
+ E[Y ] Y
X = X

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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

First we calculate the monthly price multipliers. Since we want a present value of an option we dont
use true probabilities. We use r = 0.03. The parameters of the lognormal model are
r

1
2
2 1
m = t = (r 0.5 )t = (0.03 0.5 0.15 ) = 0.0016; v = t = 0.15
= 0.0433
12
12
The stock price is calculated recursively starting with 40 and calculating each months price as the
previous months price times the multiplier.
The following table contains generation of lognormal random numbers from given standard normal
random numbers zi s:
zi = N 1 (ui )

ni = m + vzi =
xi = eni
= 0.0016 + 0.0433zi

Si = Si1 xi

-1.25

-0.0526

0.9488

37.9517

0.64

0.0293

1.0297

39.0792

-0.8

-0.0331

0.9675

37.8077

The arithmetic average of the stock prices for 3 months, is

37.9517 + 39.0792 + 37.8077
= 38.2795
3
The payoff after 3 months is:
39.5 38.2795 = 1.2205
Thus, the simulated value of the 3-month Asian arithmetic average price put option is:
e0.030.25 1.2205 = 1.2113
The geometric average of the stock prices for 3 months, is
1

(37.9517 39.0792 37.8077) 3 = 38.2753

The payoff after 3 months is:
39.5 38.2753 = 1.2247
Thus, the simulated value of the 3-month Asian geometric average price put option is:
e0.030.25 1.2247 = 1.2155
The simulated value in this run of the arithmetic average price put option using the control variate
method is:
X = 1.2113 + (0.642 1.2155) = 0.6378 0.638 
Problem 9
The time-t price of a nondividend paying stock following the Black-Scholes framework is S(t). You are
given:
(i) The current price of the stock is 55.
(ii) The continuously compounded risk-free interest rate is 0.04.
(iii) The volatility of the stock is 0.35.
A European put option on the stock with strike price 45 expires in one year. To estimate its price, simulation is used. Stratified sampling is used with four strata: [0, 0.25), [0.25, 0.50), [0.50, 0.75), [0.75, 1).
Uniform random numbers u4k+i are sent to stratum i for k 0 and 1 i 4.
Use the following four uniform random numbers u1 . . . u4 for the first four trials:
0.66

0.42

0.104

0.29
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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

Determine the resulting estimate of the options price.

Solution. The parameters of the lognormal model are

m = t = (r 0.5 2 )t = (0.04 0.5 0.352 ) = 0.0213, v = t = 0.35

Let us stratify the numbers by mapping the to the appropriate quartile:

0.66 7 0.66 0.25 = 0.1650
0.42 7 0.42 0.25 + 0.25 = 0.3550
0.104 7 0.104 0.25 + 0.5 = 0.5260
0.29 7 0.29 0.25 + 0.75 = 0.8225
The following table contains generation of lognormal random numbers from given uniform [0, 1) random
numbers ui s:

ui

zi = N 1 (ui )

0.1650

-0.9700

-0.3608

0.6972

38.3434

6.6566

0.3550

-0.3750

-0.1525

0.8586

47.2207

0.5260

0.6500

0.2063

1.2291

67.5983

0.8225

0.9250

0.3025

1.3532

74.4281

ni = m + vzi =
xi = eni
= 0.0213 + 0.35zi

Si = 55xi Payoff=45 Si

Thus, the price of the put option is:

e0.04 1.6641 = 1.5989

Problem 10
Stock prices are lognormally distributed with annual return parameters = 0.25 and = 0.10. The
stock price after 2 years is simulated using the antithetic variate method.
The following random numbers from the uniform distribution on [0, 1] are used:
0.2709

0.834

0.1515

Six trials are run.

Determine the simulated average ratio of the stock price at the end of two years to the current stock
price.
Solution. We use the three random numbers ui and their compliments 1 ui . By the symmetry of
the normal distribution, the generated standard normal numbers of the complements will be negative
the standard normal numbers generated from the originals.
The parameters of the lognormal model are

m = t = 0.25 2 = 0.5; v = t = 0.1 2 = 0.1414

The following table contains generation of lognormal random numbers from given uniform [0, 1) random
numbers ui s:

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Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. SOLUTION TO HOMEWORK 9.

ui

zi = N 1 (ui )

0.2709

-0.6100

0.4137

1.5125

0.8340

0.9700

0.6372

1.8911

0.1515

-1.0300

0.3543

1.4252

0.7291

0.6100

0.5863

1.7972

0.1660

-0.9700

0.3628

1.4374

0.8485

1.0300

0.6457

1.9073

ni = m + vzi = xi = eni
= 0.5 + 0.1414zi

Thus, the average change is:

6

1X
S(2)
1
=
xi = (1.5125 + 1.8911 + 1.4252 + 1.7972 + 1.4374 + 1.9073) = 1.6618
S(0)
6
6

i=1

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