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Simulation and Monte Carlo With applications in finance and MCMC

This book provides an introduction to the theory and practice of Monte Carlo and Simulation methods. It arises from a 20 hour course given simultaneously to two groups of students. The first are final year Honours students in the School of Mathematics at the University of Edinburgh and the second are students from Heriot Watt and Edinburgh Universities taking the MSc in Financial Mathematics. The intention is that this be a practical book that encourages readers to write and experiment with actual simulation models. The choice of programming environment, Maple, may seem strange, perhaps even perverse. It arises from the fact that at Edinburgh all mathematics students are conversant with it from year 1. I believe this is true of many other mathematics departments. The disadvantage of slow numerical processing in Maple is neutralized by the wide range of probabilistic, statistical, plotting, and list processing functions available. A large number of specially written Maple procedures are available on the website accompanying this book ( They are also listed in the Appendices.1 The content of the book falls broadly into two halves, with Chapters 1 to 5 mostly coveringthetheoryandprobabilisticaspects,whileChapters6to8coverthreeapplication areas. Chapter 1 gives a brief overview of the breadth of simulation. All problems at the end of this chapter involve the writing of Maple procedures, and full solutions are given in Appendix 1. Chapter 2 concerns the generation and assessment of pseudo-random numbers. Chapter 3 discusses three main approaches to the sampling (generation) of random variates from distributions. These are: inversion of the distribution function, the envelope rejection method, and the ratio of uniforms method. It is recognized that many other methods are available, but these three seem to be the most frequently used, and they have the advantage of leading to easily programmed algorithms. Readers interested in the many other methods are directed to the excellent book by Devroye (1986) or an earlier book of mine (Dagpunar, 1988a). Two short Maple procedures in Appendix 3 allow readers to quickly ascertain the efficiency of rejection type algorithms. Chapter 4 deals with the generation of variates from standard distributions. The emphasis is on short, easily implemented algorithms. Where such an algorithm appears to be faster than the corresponding one in the Maple statistics package, I have given a listing in Appendix 4. Taken together, I hope that Chapters 3 and 4 enable readers to understand how the generators available in various packages work and how to write algorithms for distributions that either do not appear in such packages or appear to be slow in execution. Chapter 5 introduces variance reduction methods. Without these, many simulations are incapable of giving precise estimates within a reasonable amount of processing time. Again, the emphasis is on an empirical approach and readers can use the procedures in

Appendix 5 to illustrate the efficacy of the various designs, including importance and stratified sampling. Chapters 6 and 8, on financial mathematics and Markov chain Monte Carlo methods respectively, would not have been written 10 years ago. Their inclusion is a result of the high-dimensional integrations to be found in the pricing of exotic derivatives and in Bayesianestimation.Inastrokethishascausedarenaissanceinsimulation.InChapter6,I have been influenced by the work of Glasserman (2004), particularly his work combining importance and stratified sampling. I hope in Sections 6.4.2 and 6.5 that I have provided a more direct and accessible way of deriving and applying such variance reduction methods to Asian and basket options. Another example of high-dimensional integrations arises in stochastic volatility and Section 6.6 exposes the tip of this iceberg. Serious financial engineers would not use Maple for simulations. Nevertheless, even with Maple, it is apparent from the numerical examples in Chapter 6 that accurate results can be obtained in a reasonable amount of time when effective variance reduction designs are employed. I also hope that Maple can be seen as an effective way of experimenting with various models, prior to the final construction of an efficient program in C++ or Java, say. The Maple facility to generate code in, say, C++ or Fortran is useful in this respect. Chapter 7 introduces discrete event simulation, which is perhaps best known to operational researchers. It starts with methods of simulating various Markov processes, both in discrete and continuous time. It includes a discussion of the regenerative method of analysing autocorrelated simulation output. The simulation needs of the operational researcher, the financial engineer, and the Bayesian statistician overlap to a certain extent, but it is probably true to say that no single computing environment is ideal for all application fields. An operational researcher might progress from Chapter 7 to make use of one of the powerful purpose-built discrete event simulation languages such as Simscript II.5 or Witness. If so, I hope that the book provides a good grounding in the principles of simulation. Chapter 8 deals with the other burgeoning area of simulation, namely Markov chain Monte Carlo and its use in Bayesian statistics. Here, I have been influenced by the works of Robert and Casella (2004) and Gilks et al. (1996). I have also included several examples from the reliability area since the repair and maintenance of systems is another area that interests me. Maple has been quite adequate for the examples discussed in this chapter. For larger hierarchical systems a purpose-built package such as BUGS is the answer. There are problems at the end of each chapter and solutions are given to selected ones. A few harder problems have been designated accordingly. In the text and problems, numerical answers are frequently given to more significant figures than the data would warrant. This is done so that independent calculations may be compared with the ones appearing here. I am indebted to Professor Alastair Gillespie, head of the School of Mathematics, Edinburgh University, for granting me sabbatical leave for the first semester of the 2005–2006 session. I should also like to acknowledge the several cohorts of simulation students that provided an incentive to write this book. Finally, my thanks to Angie for her encouragement and support, and for her forbearance when I was not there.

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