Problems with Monte Carlo simulation in the pricing of contingent claims

Abstract

Very often the dynamics of the interest rate and/or the risk premium do not allow to obtain a close form solution for the price of the pure discount bond. One possible approach is to use Monte Carlo simulation. In order to do this we first have to simulate the path of the stochastic variables. After doing this a number of times, we average over the different realizations. The result will be the price of the bond. In fact, very often it is assumed that the equity risk premium is zero. This is a convenient simplification, but it takes away some of the richness of equilibrium models that assume risk-averse investors.