Multilevel Nested Simulation for Efficient Risk Estimation

We investigate the problem of computing a nested expectation of the form P[E[X vertical bar Y] >= 0] = E[H(E[X vertical bar Y])] where H is the Heaviside function. This nested expectation appears, for example, when estimating the probability of a large loss from a financial portfolio. We present a method that combines the idea of using Multilevel Monte Carlo (MLMC) for nested expectations with the idea of adaptively selecting the number of samples in the approximation of the inner expectation, as proposed by [M. Broadie, Y. Du, and C. C. Moallemi, Manag. Sci., 57 (2011), pp. 1172-1194]. We propose and analyze an algorithm that adaptively selects the number of inner samples on each MLMC level and prove that the resulting MLMC method with adaptive sampling has an O(epsilon(-2)vertical bar log epsilon vertical bar(2)) complexity to achieve a root mean-squared error epsilon. The theoretical analysis is verified by numerical experiments on a simple model problem. We also present a stochastic root-finding algorithm that, combined with our adaptive methods, can be used to compute other risk measures such as Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR), the latter being achieved with O(epsilon(-2)) complexity.