IEOR E4703 Monte Carlo Simulation Method: Spring 2016

Columbia University

Objectives
The goal of this master-level course is to present the mathematical and computational methods of Monte
Carlo simulation, with an emphasis on its applications to finance. The course will begin with a rapid
review of probability distributions, statistics, and generating random numbers and samples from
specified distributions. The following topics will be covered:
(1) efficient estimation of expectations;
(2) simulating stochastic processes;
(3) simulation performance evaluation and enhancement (e.g. variance reduction techniques);
(4) pricing of financial derivatives, including European, American, and exotic derivatives, along with
sensitivity (Greeks) estimation;
(5) risk estimation via simulation, e.g. loss probability, value at risk & risk measures, as well as credit
portfolio default risks;
(6) optimal trading strategies via simulation.

Tentative Plan:

Part 1: Generating random variables: inverse transform method, composition method, & acceptance-
rejection method. Generating correlated random variables: correlated normal & copula method

Part 2: Simulation of stochastic processes: Ito diffusions (e.g. geometric Brownian motion, mean-
reverting processes), Poisson process, and jump diffusion processes. Realized variance, stochastic
drawdowns, and other path behaviors of stochastic processes.

Part 3: Monte Carlo framework and output analysis.

Part 4: Variance reduction methods: control variates, antithetics, conditional Monte Carlo, stratified
sampling, and importance sampling

Part 5: Estimation of Greeks of option prices: finite-difference method, path-wise method, likelihood
ratio method, and their combinations.

Part 6: Pricing American options using MC method.

Part 7: Risk management applications: Value-at-risk estimation, Delta-Gamma approximation,

exponential twisting, loss probability for options portfolios and credit portfolios.

Part 8: Optimal trading problems via MC simulation.

Course materials
Slides and handouts will be provided. The most relevant and recommended textbook is
Monte Carlo Methods in Financial Engineering, by Paul Glasserman, but it is not required.

Homework Policy
You're allowed to discuss HW problems with other students or consult the TA. Nevertheless, you are
required to prepare your own solution and submit work done by yourself. For instance, you
are not allowed to share the same MATLAB codes for any HW problems.
Grading: 25% HW, 30% midterm, 45% final exam.