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You are reading the 2026 curriculum (exams up to November 2026). Sitting in February 2027 or later? Go to the 2027 Quantitative Methods guide.

Monte Carlo simulation

Monte Carlo simulation builds a model, assumes a probability distribution for each uncertain input, draws thousands of random scenarios from those distributions, computes the outcome in each and summarizes the results. It handles complexity that closed-form formulas cannot, but it is only as good as the assumed distributions.

6 min cram, 30 min full read. Based on the 2026 CFA® Program Level I curriculum, Quantitative Methods, Learning Module 6. This is the 2026 version of the lesson. Sitting in February 2027 or later? Read the updated 2027 version.

Tailor this to you: take the self-assessment

Before this: Why asset prices are lognormal

On the exam

  • Describe Monte Carlo simulation and explain how it can be used in investment applications

Describe Monte Carlo simulation and explain its investment uses and limitations. Expect questions on the order of the steps, what it is used for (complex claims, risk, planning, sensitivity) and its main weakness: results depend on the assumed distributions.

How deeply to learn each part
Know the idea
Understand it in general. It frames other topics, but you will not calculate with it.
Use it
Understand it well enough to solve a question with it. Recognize when it applies.
Memorize
Learn it by heart. The exam will not give it to you.

You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.

You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.

Cram mode: the one-screen version of this lesson. Switch to Full for the explanations, worked examples and interactives.

How do you value or measure something no formula covers?

Simulate it. Monte Carlo simulation draws thousands of random scenarios from probability distributions you choose, works out the result in each one, and reads off how often each kind of outcome occurs.

Use it when the answer depends on a whole path of prices, when a security has complex embedded options, or when you want the distribution of a portfolio’s gains and losses. It fits the lognormal price model from the previous lesson: draw normal returns, convert them to prices, and see where the prices end up.

InteractiveMonte Carlo: will a retirement pot last 30 years?

Try this 0 of 3

  • Raise volatility to 18% with the expected return still at 6%, and watch the chance of lasting 30 years.
  • Switch to 1,000 trials and compare the sampling error with 100 trials.
  • Set the expected return to 4.5%, the same as the withdrawal rate.

Start: USD 1,000,000. Withdraw USD 45,000 at the end of every year for 30 years. Each year's return is a random draw from a normal distribution.

Money lasts 30 years92% (92 of 100)
Sampling error (±1 s.e.)±2.7 pts
Median balance, year 30USD 1.43m
5th percentile runs outYear 27
  • Median
  • 95th percentile
  • 5th percentile
  • A trial that lasts
  • A trial that runs out
02m4m6m8m051015202530Year of retirement (balance in USD)

100 trials drawn. Percentile lines are the balance ranked across trials each year.

Show working

Each year, on each trial: balance = last balance × (1 + R) − 45,000, with R drawn at random from a normal distribution with mean 6% and standard deviation 12%. A balance that reaches 0 stays at 0.

Repeat for 30 years, then for 100 trials. Probability the money lasts = trials with money left ÷ trials = 92 ÷ 100 = 92.0%.

Sampling error = √(p(1 − p) ÷ N) = √(0.92 × 0.08 ÷ 100) = 2.7 points. It shrinks with √N, not N.

Without randomness (every year exactly 6%) the pot would end at USD 2,185,873. The median trial ends at USD 1.43m: volatility pulls the typical outcome below the single-number forecast.

The no-randomness forecast on your calculator
  1. 2NDCLR TVM
  2. 30N6I/Y1000000+|-PV45000PMT
  3. CPTFV2,185,872.79

2ND second function (the shifted label above a key) · CLR TVM clear the time value of money keys · N number of periods · I/Y interest rate per year (per period when P/Y is 1) · +|- change sign · PV present value · PMT payment · CPT compute · FV future value

  1. fCLEAR FIN
  2. 30n6i1000000CHSPV45000PMT
  3. FV2,185,872.79

f gold shift key · CLEAR FIN clear the financial registers · n number of periods · i interest rate per period · CHS change sign · PV present value · PMT payment · FV future value

Display: 2,185,872.79

Thousands of random futures turn one guess into a range of outcomes with probabilities.

Run it with few trials and then many. With ten paths the answer jumps around, with a thousand it settles.

What are the steps?

Memorize

Six steps: three to specify the simulation, three to run it.

Six steps of a Monte Carlo simulation
Monte Carlo simulationspecify it, then run it
  • Specify the simulation Memorize steps 1 to 3
    • 1. Quantity of interest what to value or measure, and the starting values
    • 2. Time grid K sub-periods of length Δt\Delta t
    • 3. Model and distributions a distribution for each risk factor, with parameters
  • Run the simulation Memorize steps 4 to 6
    • 4. Draw and convert random numbers into prices or paths
    • 5. Compute the outcome payoff or balance, discounted if valuing
    • 6. Repeat, then summarize N trials; average or read the distribution

The thing varying from path to path is a risk factor , an uncertain input such as a share’s return. Each gets a probability distribution and parameters. Computers produce the draws by random number generation : a program creates numbers that behave as random draws from a chosen distribution, usually starting from a standard normal.

A common model for a stock moves the price by an expected drift plus a random shock, where ZZ is a standard normal draw and σ\sigma is the volatility for the step.

Simulated price step Use it
ΔS=μ Sprev Δt+σ Sprev Z\Delta S = \mu\, S_{prev}\,\Delta t + \sigma\, S_{prev}\, Z

How does it value a contingent claim?

A contingent claim is a security whose value depends on another asset, such as an option. Take a claim that pays the excess of a share’s final price over its average price during the year. No simple formula exists, because the payoff depends on the whole path. So you simulate.

One simulation trial is one complete pass through steps 4 and 5: a full path of prices, then the payoff and its present value.

Payoff of an average-price claim, one trial Use it
CT=max⁡(ST−Sˉ, 0),C0=CT(1+r)tC_T = \max\left(S_T - \bar{S},\, 0\right), \qquad C_0 = \frac{C_T}{(1+r)^{t}}

That is one trial. Repeat steps 4 and 5 for thousands of trials, then average the present values. The average is the Monte Carlo estimate of the claim’s value.

Monte Carlo estimate of value Use it
V^=1N∑i=1NCi,0\hat{V} = \frac{1}{N}\sum_{i=1}^{N} C_{i,0}

Many trials pay zero (the final price at or below the average) and a few pay a lot. Only the average of all of them is the value.

The same machinery handles other claims. A lookback claim pays the final price minus the lowest price on the path: record the minimum instead of the average. With a final price of 61.00 and a path minimum of 54.20, the payoff is 6.80.

How many trials are enough?

More trials make the estimate more precise. The standard error of the estimate falls with the square root of the number of trials, so each halving of the error costs four times as many trials.

Standard error of the estimate Use it
SE=sNSE = \frac{s}{\sqrt{N}}
Rearrange itMonte Carlo standard error: solve for any one
The question asks for
A simulation of 10000 trials gives results with a standard deviation of 3.2. The standard error of the estimate is closest to:

3.2 ÷ √10000 = 0.032

Standard error of the estimate0.032

On your calculator
  1. 3.2÷10000√x=

√x square root

  1. 3.2ENTER10000g√x÷

ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root

This is sampling error only. If the assumed distribution is wrong, ten million trials estimate the wrong thing very precisely.

What is it used for, and where does it fall short?

What Monte Carlo is used for, and where it falls short
Monte Carlo simulationa complement to analytical methods
  • Uses Memorize
    • Valuing complex claims path-dependent, embedded options, no formula
    • Risk and return distribution of portfolio gains and losses, VaR
    • Planning chance a retirement pot or liability plan fails
    • Sensitivity analysis change an assumption, rerun, compare
  • Limits Memorize
    • Depends on assumptions wrong distributions, wrong answers
    • Statistical, not exact an estimate with an error, not a proof
    • No cause and effect shows what happens, not why
    • Heavy to run needs computing power

A natural use is sensitivity analysis : because you control the assumptions, you can change one (a volatility, a correlation, a distribution), rerun and see how much the answer moves.

Monte Carlo complements analytical methods rather than replacing them. It gives statistical estimates, not exact results, and a formula, where one exists, shows cause and effect that a simulation does not.

Exam tip Monte Carlo answers “what could happen, and how likely?” It does not answer “why?”. Its single biggest weakness is the assumed distributions.

Go deeper Pseudo-random numbers and seeds

Computers produce pseudo-random numbers with a deterministic recipe started from a seed. The same seed gives the same sequence, which is useful for checking a model. A different seed gives slightly different results, which is why two runs of the same simulation never match exactly. The gap between runs is the standard error at work.

Go deeper Simulate only where you must

If a closed-form formula exists, use it: it is exact, instant and shows how the answer depends on each input. Simulation earns its place when payoffs depend on the path, when several risk factors interact, or when the instrument has embedded options. The cost is that you must make distributional assumptions, so the quality of the result is bounded by the quality of those assumptions. The next lesson shows an alternative that draws from observed data instead.

Memorize this

MemorizeThe six steps, in order

#StepPart
1Specify the quantity of interest and start valuesSpecify
2Specify the time grid (K sub-periods)Specify
3Specify the model and distributions of the risk factorsSpecify
4Draw random numbers, convert to prices or pathsRun
5Compute the outcome (and discount it)Run
6Repeat for N trials, then summarizeRun

Memory hook Three to set up, three to run. Nothing is drawn until the model and distributions are chosen.

Know it cold Result = average of the discounted trial outcomes. More trials cut the error, they do not fix wrong assumptions.

MemorizeUses and limits

UsesLimits
Complex or path-dependent claimsOnly as good as the assumed distributions
Portfolio risk and VaRStatistical estimate, not exact
Retirement and liability planningShows outcomes, not causes
Sensitivity of a model to inputsMisses events outside the assumed distribution

Memory hook "Garbage in, garbage out." The simulation draws only from what you tell it.

Know it cold Use a formula where one exists. Simulate where it does not.

Six steps of a Monte Carlo simulation
Monte Carlo simulationspecify it, then run it
  • Specify the simulation Memorize steps 1 to 3
    • 1. Quantity of interest what to value or measure, and the starting values
    • 2. Time grid K sub-periods of length Δt\Delta t
    • 3. Model and distributions a distribution for each risk factor, with parameters
  • Run the simulation Memorize steps 4 to 6
    • 4. Draw and convert random numbers into prices or paths
    • 5. Compute the outcome payoff or balance, discounted if valuing
    • 6. Repeat, then summarize N trials; average or read the distribution
What Monte Carlo is used for, and where it falls short
Monte Carlo simulationa complement to analytical methods
  • Uses Memorize
    • Valuing complex claims path-dependent, embedded options, no formula
    • Risk and return distribution of portfolio gains and losses, VaR
    • Planning chance a retirement pot or liability plan fails
    • Sensitivity analysis change an assumption, rerun, compare
  • Limits Memorize
    • Depends on assumptions wrong distributions, wrong answers
    • Statistical, not exact an estimate with an error, not a proof
    • No cause and effect shows what happens, not why
    • Heavy to run needs computing power
Simulated price step Use it
ΔS=μ Sprev Δt+σ Sprev Z\Delta S = \mu\, S_{prev}\,\Delta t + \sigma\, S_{prev}\, Z
Quick example

Price 80.00, drift 6% a year, step of a quarter, step volatility 4%, draw Z=−0.5Z = -0.5. ΔS=1.20−1.60\Delta S = 1.20 - 1.60 = −0.40, so the next price is 79.60.

On your calculator
  1. 0.06×80×0.25+(0.04×80×0.5+|-)= −0.4

+|- change sign

  1. 0.06ENTER80×0.25×0.04ENTER80×0.5CHS×+ −0.4

ENTER enter (on the HP, puts the number on the stack) · CHS change sign

Payoff of an average-price claim, one trial Use it
CT=max⁡(ST−Sˉ, 0),C0=CT(1+r)tC_T = \max\left(S_T - \bar{S},\, 0\right), \qquad C_0 = \frac{C_T}{(1+r)^{t}}
Quick example

Final price 41.00, average over the life 38.50, risk-free rate 2%, one year. Payoff 2.50, present value 2.50÷1.022.50 \div 1.02 = 2.45.

On your calculator
  1. 41−38.5=÷1.02= 2.451
  1. 41ENTER38.5−1.02÷ 2.451

ENTER enter (on the HP, puts the number on the stack)

Monte Carlo estimate of value Use it
V^=1N∑i=1NCi,0\hat{V} = \frac{1}{N}\sum_{i=1}^{N} C_{i,0}
Quick example

Five discounted payoffs 1.79, 0, 0.84, 0 and 2.40. Mean = 5.03 ÷ 5 = 1.01. A real run uses thousands of trials.

On your calculator
  1. 1.79+0.84+2.4=÷5= 1.006
  1. 1.79ENTER0.84+2.4+5÷ 1.006

ENTER enter (on the HP, puts the number on the stack)

Standard error of the estimate Use it
SE=sNSE = \frac{s}{\sqrt{N}}
Quick example

Discounted payoffs have a standard deviation of 3.20. With 10,000 trials, SE = 3.20 ÷ 100 = 0.032. Four times the trials halves it.

On your calculator
  1. 3.2÷10000√x= 0.032

√x square root

  1. 3.2ENTER10000g√x÷ 0.032

ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root

How it is asked

  1. What comes first?

    Which step comes first in a Monte Carlo valuation?

    Specify the quantity, risk factors and distributions. Drawing numbers is the trap.

  2. Main limitation

    The most important limitation of Monte Carlo simulation is…

    Results depend on the assumed distributions. Not "needs historical data" and not "cannot do path dependence".

  3. More trials

    Increasing the number of trials most likely…

    Reduces sampling error, with SE falling as √N. It does not correct the model.

  4. Quadruple the trials

    To halve the standard error, multiply the trials by…

    4, because SE ∝ 1/√N. Doubling is the trap.

Exam traps

  • Believing Monte Carlo reveals cause and effect. It estimates outcomes; analytical methods give the insight into why.
  • Believing more trials fix a wrong distribution assumption. They shrink sampling error only.
  • Putting drawing random numbers first. The model and distributions are specified before any draw.
  • Confusing Monte Carlo (draws from an assumed distribution) with bootstrapping (draws from observed data).

Checkpoint

6 exam-style questions. About 90 seconds each.

  1. 1The most important limitation of Monte Carlo simulation is that:

  2. 2Which step comes first in a Monte Carlo valuation?

  3. 3Increasing the number of trials in a Monte Carlo simulation most likely:

  4. 4A simulation of 900 trials produces discounted payoffs with a standard deviation of 4.50. The standard error of the estimated value is closest to:

  5. 5To cut the standard error of a Monte Carlo estimate to half its current size, the number of trials must be multiplied by:

  6. 6Compared with an analytical pricing formula, Monte Carlo simulation is best described as:

Key takeaways

  • Model, distributions, random draws, outcomes, repeat, summarize.
  • Best for complex claims, portfolio risk and planning, and for testing sensitivity to assumptions.
  • Only as good as its assumptions. It gives statistical estimates, not causes.
  • Standard error falls with the square root of the number of trials.
Simulated price step Use it
ΔS=μ Sprev Δt+σ Sprev Z\Delta S = \mu\, S_{prev}\,\Delta t + \sigma\, S_{prev}\, Z
Quick example

Price 80.00, drift 6% a year, step of a quarter, step volatility 4%, draw Z=−0.5Z = -0.5. ΔS=1.20−1.60\Delta S = 1.20 - 1.60 = −0.40, so the next price is 79.60.

On your calculator
  1. 0.06×80×0.25+(0.04×80×0.5+|-)= −0.4

+|- change sign

  1. 0.06ENTER80×0.25×0.04ENTER80×0.5CHS×+ −0.4

ENTER enter (on the HP, puts the number on the stack) · CHS change sign

Payoff of an average-price claim, one trial Use it
CT=max⁡(ST−Sˉ, 0),C0=CT(1+r)tC_T = \max\left(S_T - \bar{S},\, 0\right), \qquad C_0 = \frac{C_T}{(1+r)^{t}}
Quick example

Final price 41.00, average over the life 38.50, risk-free rate 2%, one year. Payoff 2.50, present value 2.50÷1.022.50 \div 1.02 = 2.45.

On your calculator
  1. 41−38.5=÷1.02= 2.451
  1. 41ENTER38.5−1.02÷ 2.451

ENTER enter (on the HP, puts the number on the stack)

Monte Carlo estimate of value Use it
V^=1N∑i=1NCi,0\hat{V} = \frac{1}{N}\sum_{i=1}^{N} C_{i,0}
Quick example

Five discounted payoffs 1.79, 0, 0.84, 0 and 2.40. Mean = 5.03 ÷ 5 = 1.01. A real run uses thousands of trials.

On your calculator
  1. 1.79+0.84+2.4=÷5= 1.006
  1. 1.79ENTER0.84+2.4+5÷ 1.006

ENTER enter (on the HP, puts the number on the stack)

Standard error of the estimate Use it
SE=sNSE = \frac{s}{\sqrt{N}}
Quick example

Discounted payoffs have a standard deviation of 3.20. With 10,000 trials, SE = 3.20 ÷ 100 = 0.032. Four times the trials halves it.

On your calculator
  1. 3.2÷10000√x= 0.032

√x square root

  1. 3.2ENTER10000g√x÷ 0.032

ENTER enter (on the HP, puts the number on the stack) · g blue shift key · √x square root

Questions about this lesson?

Where this comes back

Questions candidates ask

What is Monte Carlo simulation in finance?

It is a method that draws a large number of random scenarios from assumed probability distributions, computes the outcome in each and summarizes the results. It values complex securities with no formula and estimates the distribution of portfolio gains and losses.

What are the limitations of Monte Carlo simulation?

Results depend entirely on the assumed model and distributions, so poor assumptions give poor answers however many trials run. It gives statistical estimates, not exact values, and it shows what happens, not why. It can also be computationally heavy.

How is Monte Carlo simulation used in retirement planning?

Each trial draws random annual returns for the portfolio, applies the planned withdrawals and records whether the money lasts. Thousands of trials turn one guess into a probability of success, which is more useful than a single average projection.

Spotted an error? Tell us and we will fix it.

  1. Why asset prices are lognormal
  2. Monte Carlo simulation
  3. Bootstrapping: simulating from the data you have

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