This question relates to credit portfolio analysis. I was asked by my teacher the following question :

Why would a bank use MC simulation in the implementation of the covariance model (a bottom-up model), rather than use the analytical approach? State 2 reasons.

So far I have come up with that the co-variance model requires an estimation of loss correlation and Monte Carlo simulation can be used to generate an infinite number of scenarios of Unexpected losses from historical observations.

I don't know what the second reason for the implementation.

  • $\begingroup$ I don't buy your first reason. How about: when there are non-linear payoffs (e.g. options) the analytical approach cannot be used. $\endgroup$ – noob2 Sep 13 '16 at 13:35
  • $\begingroup$ The reason is simple; there is no analytical solution for most financial products. $\endgroup$ – SmallChess Sep 13 '16 at 23:05

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