Average Rate Option Pricing: Monte Carlo Simulation

As Black-Scholes formulas cannot be used to price average rate options, an alternative method is to use Monte Carlo simulation. We define the stochastic process that is used to create random spot prices, and then demonstrate how the Monte Carlo simulated price paths are created. We then discuss how average rate options are priced using these Monte Carlo simulations, and illustrate the pricing of an average rate call and average rate put using an example.