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CFA Level I · CFA Level I Exam · Simulation of Financial Asset Prices and Returns

An analyst wants to estimate the value of a path-dependent exotic option whose payoff depends on the average price of the underlying over its life, and no closed-form pricing formula exists. The approach most likely to be appropriate is:

Monte Carlo simulation is most appropriate because the option's payoff depends on the average price along the path and no closed-form formula exists. Simulating many price paths, computing each payoff, averaging and discounting gives an estimated value, which a single-period or closed-form approach cannot do.

  1. AMonte Carlo simulation of many price pathsCorrect
  2. Ba single-period binomial model only
  3. Ca one-factor closed-form formula

Explanation

Path-dependent payoffs need the whole price path, which Monte Carlo simulation can generate many times, then average and discount the payoffs. Closed-form or single-period approaches cannot capture the path dependence.

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