This paper develops a Monte Carlo simulation method for solving option valuation problems. The method simulates the process generating the returns on the underlying asset and invokes the risk neutrality assumption to derive the value of the option. Techniques for improving the efficiency of the method are introduced. Some numerical examples are given to illustrate the procedure and additional applications are suggested.

This paper examines some implications of using an estimate of the variance in option valuation models. This procedure produces biased option values. It is shown that the magnitude of this bias is not large. The dispersion induced in the option price is more significant particularly for parameter values of practical interest. The nature and extent of this dispersion is examined by numerical examples. The paper suggests how a Bayesian approach could be used to cope with the estimation error.