Monte Carlo Methods in

Mathematical Finance

Lecture 07:
i Importance sampling
The method of mode matching; the cross-entropy method
 Introduction
Consider the problem of estimating the expected value
µ = E[h(X)].
f
Suppose X has the density f(x).
• Plain MC: draw iid samples from f(x), then compute the sample
average of h(x).
• Importance sampling: For arbitrary density g(x), we have
f (x) f (Y )
µ= h(x)f (x)dx = h(x) · g(x)dx = E h(Y ) ,
g(x) g(Y )
R R
g
where Y is a random variable with density g .
Draw iid samples from the density !, then compute the sample
average of ℎ(#)$(#)/!(#).
The weight $(#)/!(#) is called the likelihood ratio.
 M E
g
Chen fi

MT
Generate in samples from the distribution
dep
of T

Y 72 Tn

Mn i
I
i
hiki
4
Variance of Mn

Varna Van En
É hiii
s I

É varlet fi
In Var chis gg
me O

g y c b ly fly
v

Vantil I Var E o

s
f chest fini dy c
In
gty.fm
i
R y
 Introduction
q E Ch
Importance sampling for discrete random variables:
Suppose ! is a discrete random variable with distribution
P(X = xk ) = p(xk ), k = 1, 2, · ref
·· x x
Let " be an alternative random variable with probability
distribution or x y I
P(Y = xk ) = p̄(xk ), k = 1, 2, · · ·

Importance sampling: Generate iid samples for ", then use the
sample average of
p(Y )
h(Y ) ·
p̄(Y )
as the estimate.
 How to choose the alternative distribution?
Principle of choosing alternative distributions:
The use of the alternative distribution should reduce the variance of
the estimate as much as possible.
The variance of the importance sampling estimate is
n
1 f(Yi ) 1 f(Y )
Var h(Yi ) · = Var h(Y ) · .
n i=1
g(Yi ) n g(Y )

Suppose h is nonnegative. Then the variance is minimized (=0) if

g(x) = c · h(x)f(x),
where ! is the normalization constant.

However, this choice is impractical!

Guideline of choosing ": " should be chosen to mimic ℎ($)%($).

How to choose the alternative distribution?

We will study the following methods for choosing alternative

distributions:

– Mode matching
– Cross-entropy method

matching
Match the mode of 9 x with mode of h x fix
I unto

Y info
Q argmax h x fix
x

441 fix 0 O

Into.tn x

y nfo.im a

O argmax hix Lex

x

ti ti x e x
all o

k 2 m

O Oz On
 Normal Distributions

• Consider the problem of estimating the expected value

µ = E[h(X)]
where X is a standard normal random variable, whose density
! is "(0, 1).

• Choose the alternative distribution # to be a normal

distribution with the same variance: "($,1), for some $ ∊ &.

• The likelihood ratio is

f (x) 1
= exp x+ 2
g(x) 2
 Normal Distributions

How to choose the parameter !?

É
O argue thex ha fix
The method of mode matching: ! is chosen so as to match
mode of " with the mode of ℎ($)%($).
• The mode of continuous distribution is the value x at which its
probability function has its maximum value.
• The mode of " is !, therefore, we choose
= argmaxx h(x)f (x),
i.e. the value x at which ℎ($)%($) attains its maximum.

N O 1
 Example 1: Estimate tail probability

Example: Estimate the tail probability !(" > #) , where X is a

standard normal random variable and # is large.

Plain MC:
– Generate iid samples from $(0,1)
– Compute the sample average of 1{X>a}

Importance sampling:
– Generate iid samples from $(%,1) , where %=max(#, 0)
– Compute the sample average of
f (X) 1
1{X>a} · = 1{X>a} · exp X+ 2
f (X) 2
M P x at

El Lix all
of

E
g City as

Y N o 1

h x fix
O arguex
x

t a
h lx text
Ig a
fix
f O XE c

D a a o

I
 Example 1: Estimate tail probability

300 300
a s

N O 1
200 200 a 5

100 100

0
−5 0
f5 0
−8 −6 −4 −2 0
x
2 4 d 6 8
x

d
Figure: Plain MC (left) and importance sampling (right). E
a = 5, N = 10000, exact value = 2.867 10 7
Plain MC estimate =0, IS estimate = 2.838 10 7
 Example 2: Mode Matching for Binary Call

Example: Estimate the price of a binary call option with maturity

T and payoff
1{ST K}

where under the risk-neutral probability measure, the stock

price is a geometric Brownian motion
1
St = S0 exp r 2
t + Wt .
2
 t X
s s et X woo

St Z K E

X leg er tilt

MEEE 1 Is
kl
r
e E C Lz x eat
 Example 2: Mode Matching for Binary Call
Importance sampling scheme:
• The price of the option can be written as
v=E e rT
1{ST ⇥K} = E e rT
1{X⇥b} := E[h(X)],

where X is N (0, 1) , and b = ( T ) 1 log(K/S0 ) (r 2

/2)T .
• Let f be the probability density of N (0, 1) . Then
0, if x < b
h(x)f (x) =
e rT
f (x), if x b
whose mode (maxima) is = max{b, 0}.
• Using N ( , 1) as the alternative sampling distribution, the
importance sampling estimate is the sample of average of
f (Y ) 0, if Y < b
h(Y ) · =
g(Y ) exp rT Y + 2
/2 , if Y ⇥ b
 Example 2: Mode Matching for Binary Call

Algorithm (importance sampling):

• set = max{b, 0}
• for i = 1, 2, · · · , n
generate a sample Y from N ( , 1)
set Hi = 0, if Y < b
exp rT Y + 2
/2 , if Y b
n
1
• compute the estimate v̂ = Hi
n i=1
n
1
• compute the standard error S.E. = Hi2 nv̂ 2
n(n 1) i=1
 Example 2: Mode Matching for Binary Call

Experiments with parameters:

S0 = 50, r = 0.01, = 0.1, T = 1, n = 10000
K=60:
<latexit sha1_base64="EvbLiWWtTt3xh+esLCcu27qE/cc=">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</latexit>
= 1.7732, v = 3.7522e 02, se = 5.5191e 04, re = 1.4709e 02
<latexit sha1_base64="Rdczq8JxwCPkgRzEAFBe8U+/Mvk=">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</latexit>
= 0.0000, v = 3.4355e 02, se = 1.8121e 03, re = 5.2746e 02
N O I T
K=70:
<latexit sha1_base64="7PhQaUgeQ3gJTmElGXvxDq0+0B0=">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</latexit>
= 3.3147, v = 4.5282e 04, se = 8.6958e 06, re = 1.9204e 02
<latexit sha1_base64="xdqom5jq0sgZXdCyuDVogZDCDMo=">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</latexit>
= 0.0000, v = 8.9104e 04, se = 2.9690e 04, re = 3.3320e 01

Matlab code: option_binary_IS.m

Example 3: Mode Matching for European Call

Example: Use importance sampling to estimate the price of an

European call option with maturity T and strike price K.

Compare with the plain Monte Carlo scheme.

Experiment with parameters

S0 = 50, r = 0.01, = 0.2, T = 1, n = 10000
K = 60, 80, 100, 120.

Matlab code: option_European_IS.m

n E
x Nia's

ha ha e
rt
sett FX
n étx

Y nta.IT fix

h t
O arg
x
y mode marching

ha Lex
0
Example 3: Mode Matching for European Call

• The price of the call option is

v = E[h(X)]
where X is a standard normal random variable, and
+
h(x) = S0 exp 1
2
2
T+ Tx e rT
K .

• Let ! be the probability density of "(0, 1), and # be the

alternative sampling density "($, 1) , where $ is the
maximizer of ℎ(&)!(&), which solves
1 2
ex
ex S0 exp ⇥ T +⇥ T (⇥ T )+e rT
K = 0.
2
t
1 I
Example 3: Mode Matching for European Call

Algorithm (importance sampling):

• Solve for ;
• For i = 1, 2, · · · , n
generate a sample Y from N ( , 1)
set Hi = h(Y ) exp Y + 2 /2 a
n
1
• Compute the estimate v̂ = Hi
n i=1

n
1
• Compute the standard error S.E. = Hi2 nv̂ 2
n(n 1) i=1
 Extension to General Distributions

• In the previous examples, ! is a standard normal random variable

with density "; we choose the alternative sampling distribution
from the family of #($, 1), i.e. Six f x op
e
2
g(x) = e /2
· e x f (x).
x
t e
• Generalize this to general distributions: For a general random
variable, the alternative sampling distribution is chosen from the
exponential tilt family.
 fpex c fix I C
ked fixidx
g
C

Exponential Tilt Family t

Eleox
• ! is continuous: Let " denote the density of ! . The exponential
tilt family consists of probability distributions with density
1
f (x) = e x
f (x), R.
E[e X ]
e.g. if X is normally distributed, then the exponential tilt family
consists of all normal distributions with the same variance.
• X is discrete: Let the probability mass function be p, i.e.
p(X = x) = p(x)
The exponential tilt family consists of probability distributions
with probability mass function
1
p (x) = e x
p(x), R.
E[e X ]
 X Bernoulli random variable

or i of
Pfx if P PS x o i p

Y Bernoulli

or i ol

p f y 11 p P 37 01 i f

f Prob 7 11 Egg É r

É
e f Pros 14 01
Ed P
d p

o o

E eat p t i p p ed i p
 Example 4: Application to Risk Analysis

Example: Consider a credit risk model with ! independent obligors.

Denote by pk the probability that the k-th obligor defaults and ck
the loss resulting from its default.

Assume ck = 1 for every k, and the total loss is

m m
L= ck Xk = Xk , he it de Laa
k=1 k=1 l o otherwise
where Xk is the default indicator for the k-th obligor; Xk ’s are
independent Bernoulli random variables:
P(Xk = 1) = pk , P(Xk = 0) = 1 pk .

Use importance sampling to estimate the tail probability P(L > x) ,

where " is a large threshold.
 M Prob i x E It x

T
joint dist of Xi Yz Xm

1111
L

Importance sampling

Xie f t
of le 1,2 m

g Tp
P

Tk 1 o f
t
pi i pi

d.me
pi
É O

Choice of O

Recall E
me Rob X sa
f Ipx all
X n n lo I

Y N o d

ECT a a a
É
g
For the current problem

M E C 11L Cx xm x

E I Likelihood ratio
f L y em say

E E Y x

Z E Che x

I 1
pi t o i
pi x

Pic x
k

É o

Likelihood ratio

is a 1
111,4ft It
is Y
Ifi
o
I I 1
 Example 4: Application to Risk Analysis
Important sampling scheme:
• Choose the alternative sampling distribution from the exponential
tilt family: Let Yk ’s be independent Bernoulli random variables
such that
1 pk e
p̄k = P(Yk = 1) = e · P(X k = 1) = ,
E[e Xk ] 1 + pk (e 1)
P(Yk = 0) = 1 p̄k , k = 1, 2, · · · , m
• The likelihood ratio is
m yk 1 yk
pk 1 pk
R(y1 , · · · , ym ) =
p̄k 1 p̄k
k=1

• The importance sampling estimate is the sample average of iid

copies of m
H = 1{L̄>x} · R(Y1 , · · · , Ym ), where L̄ = Yk
k=1
 Example 4: Application to Risk Analysis

Choose to make the variance of the estimate as small as possible.

2
Var[H] = E[H 2 ] (E[H]) = E[H 2 ] µ2
m 2Yk 2(1 Yk )
pk 1 pk
E[H 2 ] = E 1{L̄>x}
p̄k 1 p̄k
k=1

= E 1{L̄>x} e 2 L̄+2⇥( )
, E[H 2 ] e 2 x+2⇥( )
.
m
where ⇥( ) = log 1 + pk (e 1) .
k=1
Minimize the upper bound to determine :

min 2 x + 2⇥( ) ⇥ ( ) = x.
 Example 4: Application to Risk Analysis
Algorithm (importance sampling):
• Solve ⇥ ( ) = x for ;
• Compute the corresponding p̄k for k = 1, · · · , m
• For i = 1, 2, · · · , n
generate Yk from Bernoulli with parameter p̄k for k = 1, · · · , m
set L = Y1 + · · · + Ym Likelihood rasio
a Is xp
Yk 1 Yk
m pk 1 pk
set Hi = k=1 p̄k 1 p̄k if L > x; otherwise Hi = 0
n
1
• Compute the estimate v̂ = Hi
n i=1

n
• Compute the standard error S.E. = 1
Hi2 nv̂ 2
n(n 1) i=1
 Example 4: Application to Risk Analysis

Experiments with parameters:

m = 1000 , pk = 0.01 · (1 + e ), k = 1, 2, · · · , m
k/m

n = 10000
X=20: PIL a
= 2.0726e 01, v = 1.4653e 01, se = 1.9288e 03
<latexit sha1_base64="bYgq8ofRjeMu6WGv5jplWR8F6Dk=">AAACfHicfVHbSiNBEO0Z11vWS9RHX5oNgtehJ2NifBBEX/ZRwaxCJoSeTsU09lzsrhHCkL/wy/Ztf8UX7VyQrIoFDYdTp05VV0WZkgYZ++e4cz/mFxaXlks/V1bX1ssbm39MmmsBTZGqVN9F3ICSCTRRooK7TAOPIwW30cPlKH/7BNrINLnBQQbtmN8nsicFR0t1ys8h9gE5PaNVj51U63DE/MPwMedd+nTme8f1WjBDFeG4YxGpHIYGrOC02mhYQTCkYVh692Ies2F5NuNV8wP2jVfg1RpBfezVKVcmDozRz8CfggqZxlWn/DfspiKPIUGhuDEtn2XYLrhGKRQMS2FuIOPigd9Dy8KEx2Daxbj/kO5Ypkt7qbYvQTpmZysKHhsziCOrjDn2zcfciPwq18qx12gXMslyhERMGvVyRTGlo1PQrtQgUA0s4EJLOysVfa65QHuwkl2C//HLn0Gz6p167Pq4cn4x3cYS2Sa/yC7xyQk5J7/JFWkSQV4c6uw5+86ru+MeuEcTqetMa7bIf+HW3wDAArfb</latexit>
= 0.0000e 00, v = 1.5130e 01, se = 3.5836e 03
X=40: PIL Got
= 9.2128e 01, v = 1.4905e 07, se = 3.8022e 09
<latexit sha1_base64="etwFLmzHOvQQNoIQK60Q5gtd5D0=">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</latexit>
= 0.0000e + 00, v = 0.0000e + 00, se = 0.0000e + 00

Matlab code: credit_risk_IS.m

 The Cross-Entropy Method

Recall that the importance sampling estimate based on the

sampling density
1
g (x) = h(x)f (x)
µ
has zero variance (however, using this density as the alternative
sampling distribution is impractical).

The cross-entropy method chooses the density f (x) that is closest

to g (x) as the sampling density, i.e
g (x)
min R(g f )= log · g (x)dx,
R f (x)
where R(g f ) , the Kullback-Leibler cross entropy, measures
how close the two distributions are.
 The Cross-Entropy Method

Note that 941 In hix fix

R(g f )= g (x) log g (x)dx g (x) log f (x)dx

R R

1
= g (x) log g (x)dx h(x)f (x) log f (x)dx.
R µ R

Therefore, d f
min R(g f ) max
IP
h(x)f (x) log f (x)dx.
R

max E [h(X) log f (X)] o

f
where the random variable X has density f .

m Ecg
f
 The Cross-Entropy Method
• The maximizer is the solution to the equation
⇥ ⇥
0= E[h(X) log f (X)] = E h(X) log f (X) .
⇥ ⇥
of
• Replace the expected value by sample average:
N
1 ⇥
0= h(Xk ) log f (Xk ),
N ⇥
k=1
where Xk ’s are iid copies of X.
• The above equation can be exactly solved for normal distributions:
Suppose f (x) is the density of N (0, Im ) , f (x) is the density of
N ( , Im ), where = ( 1 , · · · , m ) Rm, then the solution is
N
ˆ= k=1 h(Xk )Xk
N
, GRM
k=1 h(Xk )

where Xk ’s are iid samples from N (0, Im ) .

 X n w to I

Y n a
go y
E x 05
Go x e

O I É ha GE I ix or

o
Ég
 Algorithm

Algorithm:
• Generate N iid pilot samples X1 , · · · , XN from density f (x);
• Compute the optimal tilting parameter ˆ ;
• For i = 1, 2, · · · , n
generate Yi from the alternative sampling density f ˆ(x)
set Hi = h(Yi ) · f (Yi )
f ˆ(Yi )
n
• Compute the estimate v̂ = 1 Hi
n i=1

n
1
• Compute the standard error S.E. = Hi2 nv̂ 2
n(n 1) i=1
 Example 5: the CE method for European call

Example: Using the cross-entropy method to compute the price

of the European call option with strike price K and maturity T .

Compare the result with the plain Monte Carlo method.

Under the risk-neutral measure, the stock price is a geometric

Brownian motion
1 2
St = S0 exp r t + Wt .
2
 Example 5: the CE method for European call

• The price of the call option is

v = E[h(X)]
where X is the standard normal random variable, and
+
1
h(x) = S0 exp 2
T+ Tx e rT
K .
2
• The alternative sampling density is chosen from the family !(",1).
• The likelihood ratio is
f (x)
l (x) = = exp x+ 2
/2
f (x)
 Example 5: the CE method for European call

Algorithm:
• Generate N iid pilot samples X1 , · · · , XN from density N (0, 1)
• Set ˆ = N k=1 h(Xk )Xk /
N
k=1 h(Xk )
• For i = 1, 2, · · · , n
generate Yi from the alternative sampling density N ( ˆ, 1)
set Hi = h(Yi ) exp ˆYi + ˆ2 /2
n
• Compute the estimate v̂ = 1 Hi
n i=1

n
1
• Compute the standard error S.E. = Hi2 nv̂ 2
n(n 1) i=1
 Example 5: the CE method for European call
Experiment with parameters
S0 = 50, r = 0.05, = 0.2, T = 1
N = 2000 pilot samples
n = 10000 samples in importance sampling
K=60:
<latexit sha1_base64="Yiv/E2rPIDCG12apGdMogkGeMZY=">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</latexit>
= 1.7647, v = 1.6174e + 00, se = 1.0986e 02
<latexit sha1_base64="zeloWIgTGDS+INOdrA4DynbJVHM=">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</latexit>
= 0.0000, v = 1.5651e + 00, se = 4.1462e 02
K=100:

<latexit sha1_base64="hT+lO7jv0W4zelNrHurrW8PlNag=">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</latexit>
= 3.7974, v = 2.4067e 03, se = 3.0039e 05
<latexit sha1_base64="TNxs2vQwivLFcUt+5Se52q4gqOM=">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</latexit>
= 0.0000, v = 3.9051e 03, se = 2.2304e 03
Matlab code: option_European_CE.m
 Example 5: the CE method for European call

K = 120:

<latexit sha1_base64="qU8l83rwLp2J2T4i6tgMeeq1k9Y=">AAACDXicbZC7SgNBFIZnvcZ4i1raDIaAhYSNCGoRCNpYhQhGhWwIZycnZnD24sxZISx5AhtfxcZCxdbezrdxNga8xB8GvvnPOcyc34+VNOS6H87U9Mzs3HxuIb+4tLyyWlhbPzdRogU2RaQifemDQSVDbJIkhZexRgh8hRf+9XFWv7hFbWQUntEgxnYAV6HsSQFkrU6h5FEfCXiV16G+490k0OW31W82mF06haJbdkfik1AZQ5GN1egU3r1uJJIAQxIKjGlV3JjaKWiSQuEw7yUGYxDXcIUtiyEEaNrpaJ0hL1mny3uRtickPnJ/TqQQGDMIfNsZAPXN31pm/ldrJdQ7aKcyjBPCUHw91EsUp4hn2fCu1ChIDSyA0NL+lYs+aBBkE8zbECp/V56E5m75sOye7hVrR+M0cmyTbbFtVmH7rMZOWIM1mWB37IE9sWfn3nl0XpzXr9YpZzyzwX7JefsE0SGaRA==</latexit>
= N aN, v = N aN, se = N aN

When K is large, the method does not produce meaning result.

This is due to the poor estimation of the tilting parameter.
 Example 6: The CE method for Asian option

Example: Compute the price of a discretely monitored average

call option with payoff (S̄ K)+ and maturity T , where S̄ is the
arithmetic mean
m
1
S̄ = Stk
m
k=1
for a given set of dates 0 < t1 < · · · < tm = T .

Assume that under the risk-neutral probability measure, the

underlying asset is a geometric Brownian motion.
1 2
St = S0 exp r t + Wt .
2
 Example 6 : The CE method for Asian option
• For k = 1, 2, · · · , m,
1
Stk = S0 exp r 2
tk + Wtk
2
1
= S0 exp r 2
(tk 1 + (tk tk 1 )) + Wtk + tk tk 1 Zk
2 1

1
= Stk exp r 2
(tk tk 1) + tk tk 1 Zk
1
2
where Z1 , · · · , Zm are iid standard normal random variables.

• The discounted option payoff can be written as a function of the

m-dimensional standard normal random vector:
h(X) = e rT
(S̄ K)+ .
 Example 6 : The CE method for Asian option
• Denote the joint density function of X by f ,
m m
1 1
f (x) = exp x2i .
2 2
k=1
• Choose the alternative sampling distribution from the family
of N ( , Im ) , where Rm, i.e.
m m
1 1
f (x) = exp (xi i)
2
.
2⇥ 2
k=1

• The importance sampling estimate is the sampling average of

iid copies of
m m
f (Y ) 1
h(Y ) · = h(Y ) exp Y
i i + 2
,
f (Y ) 2 i
k=1 k=1

where Y has distribution N ( , Im ) .

 Example 6 : The CE method for Asian option

Choice of the tilting parameter (cross-entropy algorithm):

Let X1 , · · · , XN be iid pilot samples from the original distribution

N (0, Im ), then is given by

N
ˆ= i=1 h(Xi )Xi
N
.
i=1 h(Xi )
 Example 6 : The CE method for Asian option

Algorithm (computation of the tilting parameter):

• For k = 1, 2, · · · , N
for j = 1, 2, · · · , m
generate Zj from N (0, 1)
set Stj = Stj 1 exp r 2
/2 (tj tj 1) + tj tj 1 Zj

set Hk = e rT
(S̄ K)+
N
• Set ˆ = ( ˆ1 , · · · , ˆm ) = k=1 Hk Xk
N
k=1 Hk
 Example 6 : The CE method for Asian option
Algorithm (cross-entropy):
• Compute the tilting parameter using pilot samples
• For i = 1, 2, · · · , n
for j = 1, 2, · · · , m
generate Yj from N ( ˆj , 1)
set Stj = Stj 1 exp r 2
/2 (tj tj 1 ) + tj tj 1 Yj

compute the discounted payoff x the likelihood ratio

m m
Hi = e rT
(S̄ K)+ · exp ˆj Yj + 1 ˆ2 ,
j=1
2 j=1
j

n
• Compute the estimate v̂ = 1
n i=1 Hi
n
1
• Compute the standard error S.E. = Hi2 nv̂ 2
n(n 1) i=1
Example 6 : The CE method for Asian option
Experiment with parameters
S0 = 50, r = 0.05, = 0.2 T = 1, m = 12, ti = i/m
N = 2000, n = 10000

K=50:
v = 3.0722e + 00,
<latexit sha1_base64="EMyFFqcayuN9JI7E0+p7V+dTfUk=">AAACGHicbVDLTgIxFO34RHyhLt00EhMTddIZMeiChOjGJSYiJEBIp1ygofOw7ZCQCb/hxl9x40KNW3b+jeWxUPAkNzk559723uNFgitNyLe1tLyyurae2khvbm3v7Gb29h9VGEsGZRaKUFY9qkDwAMqaawHVSAL1PQEVr3c79it9kIqHwYMeRNDwaSfgbc6oNlIzQ/qFC5vkXRdOCTmrP8W0hZP65N3EEzEMsYICduxLks/BOXGHzUyW2GQCvEicGcmiGUrNzKjeClnsQ6CZoErVHBLpRkKl5kzAMF2PFUSU9WgHaoYG1AfVSCYbDPGxUVq4HUpTgcYT9fdEQn2lBr5nOn2qu2reG4v/ebVYt68aCQ+iWEPAph+1Y4F1iMcx4RaXwLQYGEKZ5GZXzLpUUqZNmGkTgjN/8iIpu/a1Te5z2eLNLI0UOkRH6AQ5KI+K6A6VUBkx9Ixe0Tv6sF6sN+vT+pq2LlmzmQP0B9boB3G4nQs=</latexit>
se = 1.5074e 02
v = 3.1192e + 00,
<latexit sha1_base64="y4ehYKeXdVP0f0FkA8NxliciCaE=">AAACGHicbVBNS0JBFJ1nX2ZfVss2QxIE1WPeSygXgtSmpUGmoCLzxqsOzvtoZp4gD/9Gm/5KmxYVbd31bxo/FqUduHA4596Ze48XCa40Id9WamV1bX0jvZnZ2t7Z3cvuHzyqMJYMKiwUoax5VIHgAVQ01wJqkQTqewKqXv924lcHIBUPgwc9jKDp027AO5xRbaRWlgyKl7bjFFw4I+S88RTTNk4a03cTT8QwwgqKOG+7eVKAC+KOWtkcsckUeJk4c5JDc5Rb2XGjHbLYh0AzQZWqOyTSzYRKzZmAUaYRK4go69Mu1A0NqA+qmUw3GOETo7RxJ5SmAo2n6u+JhPpKDX3PdPpU99SiNxH/8+qx7lw3Ex5EsYaAzT7qxALrEE9iwm0ugWkxNIQyyc2umPWopEybMDMmBGfx5GVSce2CTe7zudLNPI00OkLH6BQ56AqV0B0qowpi6Bm9onf0Yb1Yb9an9TVrTVnzmUP0B9b4B3gjnQ8=</latexit>
sha1_base64="bc7eh2/3vltQbBGUTaMbC6iE2Xw=">AAAB43icbVBNS8NAEJ34WeNX9eplsQieSuJFvQlePFYwttCGstls2qWb3bA7EUroH/DgRfHqf/Lmv3H7AWrrg4HHezPMzEsKKSwGwZe3tr6xubVd2/F39/z9g8P60aPVpWE8Ylpq00mo5VIoHqFAyTuF4TRPJG8no9up337ixgqtHnBc8DinAyUywSg6qdWvN4JmMANZJeGCNGCBfv2zl2pW5lwhk9TabhgUGFfUoGCST/xeaXlB2YgOeNdRRXNu42p25oScOSUlmTauFJKZ+nuiorm14zxxnTnFoV32puJ/XrfE7CquhCpK5IrNF2WlJKjJ9GeSCsMZyrEjlBnhbiVsSA1l6JLxXQbh8serJLpoXjeD+58soAYncArnEMIl3MAdtCACBik8w6s39F68N+993rjmLSaO4Q+8j2+HZIrV</latexit>
sha1_base64="QnUEiIBAulIC5clHBA0Leqz3Zcs=">AAACGHicbVDLSgNBEOz1bXxFPXoZDIKgLrMxoDkEBC8eIxgjZEOYnXR0cPbhzKwQlvyGF3/FiwcVr7n5N042AZ8FDUVV90x3BYkU2lD64UxNz8zOzS8sFpaWV1bXiusblzpOFccGj2WsrgKmUYoIG0YYiVeJQhYGEpvB7enIb96j0iKOLkw/wXbIriPRE5wZK3WK9L526HpetYx7lO77dynrkszP380CmeKAaKyRiluu0Coe0PKgUyxRl+Ygf4k3ISWYoN4pDv1uzNMQI8Ml07rl0cS0M6aM4BIHBT/VmDB+y66xZWnEQtTtLN9gQHas0iW9WNmKDMnV7xMZC7Xuh4HtDJm50b+9kfif10pN77idiShJDUZ8/FEvlcTEZBQT6QqF3Mi+JYwrYXcl/IYpxo0Ns2BD8H6f/Jc0ym7VpedfYcACbME27IIHR3ACZ1CHBnB4gCd4gVfn0Xl23pz3ceuUM5nZhB9whp9PiZyJ</latexit>
sha1_base64="C9toxqz8+MlxzUaCYLwSVNw3c3Q=">AAACGHicbVBNS0JBFJ1nX2ZfVss2QxIE1WPeSygXgtSmpUGmoCLzxqsOzvtoZp4gD/9Gm/5KmxYVbd31bxo/FqUduHA4596Ze48XCa40Id9WamV1bX0jvZnZ2t7Z3cvuHzyqMJYMKiwUoax5VIHgAVQ01wJqkQTqewKqXv924lcHIBUPgwc9jKDp027AO5xRbaRWlgyKl7bjFFw4I+S88RTTNk4a03cTT8QwwgqKOG+7eVKAC+KOWtkcsckUeJk4c5JDc5Rb2XGjHbLYh0AzQZWqOyTSzYRKzZmAUaYRK4go69Mu1A0NqA+qmUw3GOETo7RxJ5SmAo2n6u+JhPpKDX3PdPpU99SiNxH/8+qx7lw3Ex5EsYaAzT7qxALrEE9iwm0ugWkxNIQyyc2umPWopEybMDMmBGfx5GVSce2CTe5JrnQzTyONjtAxOkUOukIldIfKqIIYekav6B19WC/Wm/Vpfc1aU9Z85hD9gTX+AXbjnQs=</latexit>
se = 4.2409e 02 (Plain MC)

K=70:
v = 1.7195e
<latexit sha1_base64="z5jEIVoaf5m2IG8lbiVow4hNNPU=">AAACF3icbVDLTgIxFO3gC/E16tJNIzFxoThDIMiChOjGJSYiJMyEdMoFGjoP2w4JmfAZbvwVNy7UuNWdf2N5LBS8SZPTc869vT1exJlUlvVtpFZW19Y30puZre2d3T1z/+BehrGgUKchD0XTIxI4C6CumOLQjAQQ3+PQ8AbXE70xBCFZGNypUQSuT3oB6zJKlKba5sWwYudKdrkI51b+zHmISQcnznRu4vEYxlhCpZizrFJZOwrjtpm19G1SeBnYc5BF86q1zS+nE9LYh0BRTqRs2Vak3IQIxSiHccaJJUSEDkgPWhoGxAfpJtMFxvhEMx3cDYU+gcJT9ndHQnwpR76nnT5RfbmoTcj/tFasupduwoIoVhDQ2UPdmGMV4klKuMMEUMVHGhAqmN4V0z4RhCqdZUaHYC9+eRnU87lyzrotZKtX8zTS6Agdo1NkoxKqohtUQ3VE0SN6Rq/ozXgyXox342NmTRnznkP0p4zPHy12nPQ=</latexit>
02, se = 5.0079e 04
v = 2.1344e
<latexit sha1_base64="qXMhOh062gVXyW6imM7FtasV88Y=">AAACF3icbVDLTgIxFO3gC/GFunTTSExc6DgD+GBBQnTjEhMREoaQTucCDZ2HbYeETPgMN/6KGxdq3OrOv7E8FoqepMnJOee2t8eNOJPKsr6M1MLi0vJKejWztr6xuZXd3rmTYSwo1GjIQ9FwiQTOAqgppjg0IgHEdznU3f7V2K8PQEgWBrdqGEHLJ92AdRglSkvt7MmgnDftQrEIx1b+yLmPiYcTZ3Jv4vIYRlhCuWCentklnSiM2tmcZVoT4L/EnpEcmqHazn46XkhjHwJFOZGyaVuRaiVEKEY5jDJOLCEitE+60NQ0ID7IVjJZYIQPtOLhTij0CRSeqD8nEuJLOfRdnfSJ6sl5byz+5zVj1bloJSyIYgUBnT7UiTlWIR63hD0mgCo+1IRQwfSumPaIIFTpLjO6BHv+y39JLW+WTOummKtcztpIoz20jw6Rjc5RBV2jKqohih7QE3pBr8aj8Wy8Ge/TaMqYzeyiXzA+vgEhjZzt</latexit>
02, se = 3.5619e 03 (Plain MC)

Matlab code: option_asian_CE.m

Appendix
 Matlab function for example 2
(mode matching for the binary option)
function [v, se] = option_binary_IS(s0, r, sigma, T, K, n)

% s0 - initial stock price; r - risk-free interest rate;

% sigma - volatility; T - terminal time; K - strike price; n - sample size.

b=1/(sigma*sqrt(T))*(log(K/s0)-(r-sigma^2/2)*T);
theta=max(b,0); % tilting parameter

y=theta+randn(n,1); % iid samples from the tilted distribution

H=(y>=b).*exp(-r*T-theta*y+theta^2/2); % discounted payoff x the likelihood ratio

v = sum(H)/n; % MC estimate of the value of the option

se = sqrt((sum(H.^2) - n*v^2)/n/(n-1)); % estimate of the standard error
re=se/v;

fprintf('\n theta=%8.4e, v=%8.4e, se=%8.4e, re=%8.4e\n',theta, v, se,re);

 Matlab function for example 3
(mode matching for European call)
function [v, se, vexact] = option_European_IS(s0, r, sigma, T, K, n)
% s0 - initial stock price; r - risk-free interest rate;
% sigma - volatility; T - terminal time; K - strike price; n - sample size.
f=@(theta)fun(theta, s0, r, sigma, T, K); % define a function handle f
theta = fzero(f, 10); % find the zero of f; or using fsolve(f, 10)
y=theta+randn(n,1); % iid samples from the tilted distribution N O 1
H=max(s0*exp(-0.5*sigma^2*T+sigma*sqrt(T)*y)-exp(-r*T)*K, 0); %discouted payoff
H=H.*exp(-theta*y+theta^2/2); % discounted payoff x the likelihood ratio
v = sum(H)/n; % MC estimate of the value of the option
se = sqrt((sum(H.^2) - n*v^2)/n/(n-1)); % estimate of the standard error
% exact value from Black-Scholes formula
tmp=1/(sigma*sqrt(T))*log(K/s0)+(sigma/2-r/sigma)*sqrt(T);
vexact=s0*normcdf(sigma*sqrt(T)-tmp)-K*exp(-r*T)*normcdf(-tmp);
fprintf('\n theta=%8.4e, v=%8.4e, se=%8.4e, vexact=%8.4e\n',theta, v, se, vexact);
 Matlab function for example 3
(mode matching for European call)

function F=fun(theta, s0, r, sigma, T, K)

F=s0*exp(-0.5*sigma^2*T+sigma*sqrt(T)*theta)*(sigma*sqrt(T)-theta) …
+exp(-r*T)*K*theta;

day fhlxl.fm I 0
 Matlab function for example 4
(Application to Risk Analysis)
function [v, se] = credit_risk_IS(m, c, p, x, n)
% m: number of obligors; c(1:m): the loss from default
% p(1:m): probability of default; x: threshold; n - sample size.
f=@(theta)fun(theta, p, x); % define a function handle f
if x <= sum(c.*p)
theta=0; % use plain MC if x is not large
else
theta = fzero(f, 10); % find the zero of f;
end
pbar = p* exp(theta)./(1+ p*(exp(theta)-1)); % titled probability mass function
for i=1:n
y=rand(m,1)<=pbar; % iid samples from the tilted Bernoulli distribution
L =sum(c.*y); % total loss
lr=prod(((p./pbar).^y).*(((1-p)./(1-pbar)).^(1-y))); %likelihood ratio
H(i)=(L>x)*lr;
end
 Matlab function for example 4
(Application to Risk Analysis)
v = sum(H)/n; % MC estimate
se = sqrt((sum(H.^2) - n*v^2)/n/(n-1)); % estimate of the standard error

fprintf('\n theta=%8.4e, v=%8.4e, se=%8.4e\n',theta, v, se);

function F=fun(theta, p, x)
F=sum(p*exp(theta)./(1+p*(exp(theta)-1))) -x;
 Matlab function for example 5
(The CE method for European call)
function [v, se, vexact] = option_European_CE(s0, r, sigma, T, K, n)
% s0 - initial stock price; r - risk-free interest rate;
% sigma - volatility; T - terminal time; K - strike price; n - sample size.
h=@(x)payoff(x,s0,r,sigma,T,K); % define a handle for the discounted payoff function
% compute the titling parameter using pilot samples
N=2000; x=randn(N,1); tmp=h(x);
theta = sum(tmp.*x)/sum(tmp);
y=theta+randn(n,1); % iid samples from the tilted distribution
H=h(y).*exp(-theta*y+theta^2/2); % discounted payoff x the likelihood ratio
v = sum(H)/n; % MC estimate of the value of the option
se = sqrt((sum(H.^2) - n*v^2)/n/(n-1)); % estimate of the standard error
% exact value from Black-Scholes formula
tmp=1/(sigma*sqrt(T))*log(K/s0)+(sigma/2-r/sigma)*sqrt(T);
vexact=s0*normcdf(sigma*sqrt(T)-tmp)-K*exp(-r*T)*normcdf(-tmp);
fprintf('\n theta=%8.4e, v=%8.4e, se=%8.4e, vexact=%8.4e\n',theta, v, se, vexact);
 Matlab function for example 5
(The CE method for European call)
function h = payoff(x,s0,r, sigma, T, K)
h=max(s0*exp(-0.5*sigma^2*T+sigma*sqrt(T)*x)-exp(-r*T)*K, 0);
 Matlab function for example 6
(The CE method for Asian option)
function [v, se] = option_asian_CE(s0, r, sigma, T, m, K, n)
% s0 - initial stock price; r - risk-free interest rate;
% sigma - volatility; T - terminal time; m - number of monitor dates;
% K - strike price; N: number of pilot samples; n - sample size.
t=[0: 1/m: 1]*T; % m monitoring dates
dt=t(2:m+1)-t(1:m);
% compute the tilting parameter using the basic cross entropy method
tmp1=zeros(m,1);
tmp2=0;
N=2000; % number of pilot samples
for i=1:N
samplefrom N10,2m
z=randn(m,1);
stock price
s=gBM(s0, r, sigma, m, dt, z); path for
H=exp(-r*T)*max(sum(s(2:m+1))/m -K,0); % payoff for the k-th path
tmp1=tmp1+H*z;
tmp2=tmp2+H;
end
 Matlab function for example 6
(The CE method for Asian option)
theta= tmp1/tmp2; % tilting parameter
% important sampling
for i=1:n % loops to generate n sample paths and payoffs
y=randn(m,1)+theta; NCO Imm
s=gBM(s0,r,sigma,m,dt,y);
H(i)=exp(-r*T)*max(sum(s(2:m+1))/m -K,0); %discounted payoff
H(i)=H(i)*exp(-sum(theta.*y)+0.5*sum(theta.^2)); % likelihood ratio
end
v=sum(H)/n;
se = sqrt((sum(H.^2) - n*v^2)/n/(n-1)); % estimate of the standard error
fprintf('\n v=%8.4e, se=%8.4e\n', v, se);
% generate a discrete path of geometric Bronian motion
function s=gBM(s0, r, sigma, m, dt, z)
s(1) =s0;
for k=2:m+1
s(k) = s(k-1)*exp((r-0.5*sigma^2)*dt(k-1)+sigma*sqrt(dt(k-1))*z(k-1));
end