An Efficient Rare Event Simulation-Based Methodology for Pricing and Risk Management of Financial Derivatives

The severity and occurrence of rare events in financial markets has had a fundamental impact on the pricing and risk management of financial derivatives, such as volatility smile curves. However rare event modelling poses a problem in efficient and accurate simulation due to fundamental issues in small probability estimations. In this paper, we propose a simulation-based methodology for financial applications that require rare event estimations. We present three key applications: barrier options under Heston stochastic volatility, the associated option deltas, gammas and vegas, and CDS pricing that our method demonstrates its superior efficiency, accuracy and flexibility compared to pertinent Monte Carlo methods