A numerical method originally utilised to build and test the
atomic bomb during
World War II.
A Monte Carlo simulation typically - and in a
random manner - creates hundreds of thousands of
simulated solutions, and then ranks these solutions in a
statistical manner.
Monte Carlo Simulation was required during
WWII due to the large
number of
variables involved in the
design of Atomic Weapons, as well as the lack of what is called a
closed form solution, in other words a precise mathematical
formula that defines the desired
answer.
Using Monte Carlo Simulation the most likely outcome can be arrived at within a specified statistical
confidence interval.
In the civilian world, Monte Carlo Simulation is most commonly used in
finance to determine the value of a
position of instruments, particularly involving the so-called
non-linear variety.
Instruments which exhibit these characteristics are more commonly known as
derivatives.
The valuation of derivatives at times also involves large numbers of variables and, like atomic weapons design, does not lend itself easily to closed form solutions.