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 option whose payoff depends on the average price of the underlying over its life. Which approach is most appropriate?
Monte Carlo simulation is most appropriate because the payoff depends on the entire price path. Simulating many paths, computing each average-based payoff, and discounting the mean payoff handles this, whereas final-price formulas or one-period trees cannot capture path dependence.
- AMonte Carlo simulation of price pathsCorrect
- BA closed-form formula applied to the final price
- CA single-period binomial tree
Explanation
Path-dependent payoffs depend on the whole price path, so many simulated paths are generated, the payoff is computed on each, and the average discounted payoff is the estimate. A formula using only the final price ignores the path, and a one-period tree has no path.
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