CFA Level I · CFA Level I Exam · Simulation of Financial Asset Prices and Returns
Which statement best describes why an analyst might simulate asset prices using a lognormal model rather than directly modeling prices as normally distributed?
A lognormal model prevents negative prices and reflects the compounding of returns over time. Continuously compounded returns are normal, so prices are exponential functions of them. Volatility must still be estimated, and prices can fall below the starting value.
- AIt removes the need to estimate volatility
- BIt guarantees simulated prices exceed the starting price
- CIt prevents negative prices and reflects compounding of returnsCorrect
Explanation
Lognormal modeling follows from normally distributed continuously compounded returns, which compound multiplicatively and keep prices positive. Volatility must still be estimated. Prices can fall below the starting level.
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