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Monte Carlo Simulation

Trading Term

A Monte Carlo simulation is a mathematical technique used to estimate the probability of different outcomes when a system involves uncertainty or randomness. It works by running a large number of simulated scenarios, each time using randomly generated inputs drawn from specified probability distributions.

How it works:

  • Define the variables that are uncertain (e.g., stock returns, interest rates).
  • Assign probability distributions to those variables.
  • Run thousands or millions of simulations.
  • Observe the range of outcomes and their likelihood.

Why it’s used:

Monte Carlo simulations help analysts understand risk, volatility, and the probability of extreme outcomes in fields like finance, engineering, and physics. In investing, it’s commonly used for portfolio risk analysis, valuation, and forecasting.

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