Monte Carlo Simulations: why do we use the arithmetic mean and not the drift?

Generic
1

I am in the EPAT course batch 54. In the module SFM 02, part 3, me saw that the arithmetic mean is not appropiate to use when estimating prices. Instead, we need to use the drift.

Nevertheless, during the lecture, in the Monte Carlo simulations we are using the arithmetic mean of the returns.

Does anyone know why we don't use the drift instead?

2

Hi Maximiliano,



For smaller intervals, drift is minimal. The drift is negligible since we are running the Monte Carlo simulations using daily prices. However, we have to incorporate drift when computing the returns for longer durations. 



For example, we would have to use drift if we tried to simulate the 20th-day prices directly without calculating the daily prices in between. But since we are calculating the price for each day in the lecture, we ignore the drift.



Hope this helps!



Thanks,

Akshay