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

Compared with analytical valuation formulas, Monte Carlo simulation is most likely preferred for pricing an option whose payoff:

Monte Carlo is most useful when the payoff depends on the full price path, as with Asian or barrier options. Such products often lack closed-form formulas, while linear or terminal-price-only payoffs can usually be valued analytically.

  1. Adepends on the full path of the underlying priceCorrect
  2. Bdepends only on the terminal price of the underlying
  3. Cis a simple linear function of the underlying price

Explanation

Path-dependent payoffs, such as Asian or barrier options, often lack closed-form solutions, so simulating many price paths is useful. Simple or terminal-price-only payoffs often have analytical solutions.

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