Monte Carlo

Simulation
Natalia A. Humphreys
April 6, 2012
University of Texas at Dallas
Aknowledgement
Wayne L. Winston, Microsoft Excel Data Analysis
and Business Modeling, 2004
Overview
Part I
Questions answered with the help of MCS
History
Typical simulations
Part II: Simulation examples
Part III: Advantages of MCS over deterministic
analysis




Challenges

We are constantly faced with uncertainty, ambiguity,
and variability.
Risk analysis is part of every decision we make.
Wed like to accurately predict (estimate) the
probabilities of uncertain events.
Monte Carlo simulation enables us to model
situations that present uncertainty and play them
out thousands of times on a computer.
Questions answered
with the help of MCS
How should a greeting card company determine
how many cards to produce?
How should a car dealership determine how many
cars to order?
What is the probability that a new products cash
flows will have a positive net present value (NPV)?
What is the riskiness of an investment portfolio?
Modeling with MCS
Monte Carlo Simulation (MCS) lets you see all the
possible outcomes of your decisions and assess the
impact of risk, allowing for better decision making
under uncertainty.
MCS: Where did the
Name Come From?
During the 1930s and 1940s, many computer
simulations were performed to estimate the probability
that the chain reaction needed for the atom bomb would
work successfully.
The Monte Carlo method was coined then by the
physicists John von Neumann, Stanislaw Ulam and
Nicholas Metropolis, while they were working on this and
other nuclear weapon projects (Manhattan Project) in the
Los Alamos National Laboratory.
It was named in homage to the Monte Carlo Casino, a
famous casino in the Monaco resort Monte Carlo where
Ulam's uncle would often gamble away his money.

Who Uses MCS?
General Motors (GM)
Procter and Gamble (P&G)
Eli Lilly
Wall Street firms
Sears
Financial planners
Other companies, organizations and individuals
MCS Use
General Motors (GM), Procter and Gamble (P&G),
and Eli Lilly use simulation to estimate both the
average return and the riskiness of new products.
MCS Use: GM
Forecast net income for the corporation
Predict structural costs and purchasing costs
Determine its susceptibility to different risks:
Interest rate changes
Exchange rate fluctuations
MCS Use: Lilly

Determine the optimal plant capacity that should be
built for each drug
MCS Use: Wall Street

Price complex financial derivatives
Determine the Value at Risk (VaR) of investment
portfolios.
By definition, Value at Risk at security level p for a
random variable X is the number VaR_p(X) such that
Pr(X<VaR_p(X))=p
In practice, p is selected to be close to 1: 95%, 99%,
99.5%
MCS Use: Procter &
Gamble
Model and optimally hedge foreign exchange risk
MCS Use: Sears
How many units of each product line should be
ordered from suppliers
MCS Use: Financial
Planners
Determine optimal investment strategies for their
clients retirement.
MCS Use: Others
Value real options:
Value of an option to expand, contract, or postpone a
project
MCS Applications
Physical Sciences
Engineering
Computational Biology
Applied Statistics
Games
Design and visuals
Finance and business (Actuarial Science)
Telecommunications
Mathematics
Part II
Well now discuss how Monte Carlo simulation
works by looking at a few simulation examples
=RAND() function
When you enter the formula =RAND() in a cell, you
get a number that is equally likely to assume any
value between 0 and 1.
Get a number less than or equal to 0.25 around 25% of
the time
Get a number that is at least 0.9 around 10% of the
time
Example 1: Discrete
Random Variable
Simulation
Demand for a calendar is governed by the following
discrete r.v.:

DEMAND PROBABILITY
10,000 0.10
20,000 0.35
40,000 0.30
60,000 .25
Discrete r.v.
Simulation(cont.)
How can we have Excel play out, or simulate, this
demand for calendars many times?
We associate each possible value of the RAND
function with a possible demand for calendars.


Discr r.v. Sim (cont.)

The following assignment ensures that a demand of
10,000 will occur 10 percent of the time, and so on.



DEMAND RANDOM NUMBER ASSIGNED
10,000 Less than 0.10
20,000 Greater than or equal to 0.10 and less than
0.45
40,000 Greater than or equal to 0.45 and less than
0.75
60,000 Greater than or equal to 0.75
Discr r.v. Sim (cont.)
Creating the following cutoff table, we then use it to
look up the values assigned to each random
number:




CUTOFF DEMAND
0 10,000
0.1 20,000
0.45 40,000
0.75 60,000
TRIAL RAND SIM
DEMAND
1
0.823097422
60,000

2
0.076074298
10,000

3
0.364201634
20,000

4
0.698116365
40,000

Discr r.v. Sim (cont.)

The function used to create the values in the third
column of the second table is called the VLOOKUP
function.
Its syntax in Excel is:
VLOOKUP( lookup_value, table_array,
col_index_num, range_lookup )



Discr r.v. Sim (cont.)

Thus, the VLOOKUP(0.823097422, LOOKUP, 2,
1)=60,000
TRUE=1, FALSE=0
If VLOOKUP can't find lookup value, and range
lookup is TRUE, it uses the largest value that is less
than or equal to lookup value.



Discr r.v. Sim (cont.)
If we simulate 400 values of calendar demand and
then calculate the fraction of time each demand
appears in the simulation, well get a table similar to
the following:


DEMAND FRACTION
OF TIME
10,000
0.10250
20,000
0.35500
40,000
0.29250
60,000
0.25000
DEMAND PROBABILI
TY
10,000 0.10
20,000 0.35
40,000 0.30
60,000 0.25
Example 2: Normal
Random Variable
Simulation
Suppose we want to simulate 400 trials or iterations
for a normal r.v. with a mean =40,000 and
standard deviation =10,000
What is a normal random variable?
Let us first define the standard normal random
variable.
Standard Normal
Random Variable
Its distribution has a form of a bell curve around
the zero.
Standard Normal Distribution Table is a table that
shows probability that a standard normal random
variable Z is less than a number z:
(z)=Pr(Z<z)
A standard normal r.v. Z is a r.v. with =0 and =1

Connection between
any Normal r.v. and a
Standard Normal r.v.


If Z is N(0, 1) and is Y is N(, ^2), then
Y=Z+
Normal Random
Variable Simulation
Suppose we want to simulate 400 trials or iterations
for a normal r.v. with a mean =40,000 and
standard deviation =10,000
The formula NORMINV(RAND(), , ) will generate
a simulated value of a normal r.v. having a mean
and standard deviation .

Normal r.v. Sim (cont.)



33,518.16 = NORMINV(0.258433031, 40,000, 10,000)
This value could also be looked up using the
Standard Normal Distribution table.

TRIAL RAND NORMAL RV
1 0.258433031 33,518.16
2 0.344835199 36,006.98
3 0.927522163 54,575.82
4 0.248403053 33,204.76

Example 3: How Many
Cards to Produce?
Suppose the demand for a Valentines Day card is
governed by the following discrete r.v.:
DEMAND PROBABILITY
10,000 0.10
20,000 0.35
40,000 0.30
60,000 .25
Cards to Produce?
(cont.)
The greeting card sells for $4.00
The variable cost of producing each card is $1.50
Leftover cards will be disposed at $0.20 per card

How many cards should be printed to get
the highest profit?
Cards to Produce?
(cont.)
We simulate each possible production quantity
(10,000, 20,000, 40,000 or 60000) many times (e.g.
1,000 iterations)
Then we determine which order quantity yields the
maximum average profit over the 1,000 iterations
Cards to Produce?
(cont.)

1 produced 10,000
2 rand 0.400927091
3 demandcard 20,000
4 unit prod cost $1.50
5 unit price $4.00
6 unit disp cost $0.20
7 revenue $40,000.00
8 total var cost $15,000.00
9 total disposing cost $-
10 profit $25,000.00
Cards to Produce?
(cont.)
Our sales and cost parameters are in 4, 5, and 6
Enter a trial production quantity in 1
Create a random number in 2 with =RAND()
Simulate demand for the card in 3 with
VLOOKUP(rand, lookup, 2)
The number of unites sold is
MIN (Production Quantity, Demand)

Cards to Produce?
(cont.)
Revenue in 7: MIN (Produced, Demand)*unit price
Total production cost in 8: produced*unit production
cost
If we produce more cards than are demanded, the
number of units left over equals production minus
demand


Cards to Produce?
(cont.)
Disposal cost in 9:
unit disposal cost*MAX(produced-demand, 0)
Total profit in 10:
Revenue total var cost total disposing cost
Cards to Produce?
(cont.)
We would like an efficient way to calculate profit for
each production quantity
Well use a two-way data table

mean (ave
profit) 24,985 45,984 57,311 44,218
st dev
(risk) - 12,321.19 48,346.89 73,622.44
25,000 10,000 20,000 40,000 60,000
1 25000 50000 16000 -60000
2 25000 50000 100000 66000
3 25000 50000 16000 66000
4 25000 50000 100000 150000
5 25000 50000 100000 -18000
Cards to Produce?
(cont.)
Enter 1-1000 on the left corresponding to our 1,000
trials
Enter possible production quantities (third row)
We want to calculate profit for each trial number and
each production quantity
Refer to the formula for profit in the upper left cell of
our data table by entering =B11
We are now ready to trick Excel into simulating
1,000 iterations of demand for each production
quantity.
Cards to Produce?
(cont.)
Select the table range and then click Table on the
Data menu.
Click on any blank cell (e.g. I14) as the column
input cell and choose production quantity (cell B1)
as the row input cell.
We calculate the average simulated profit for each
production quantity
We calculate the standard deviation of simulated
profits for each production quantity



Cards to Produce?
Conclusion
Producing 40,000 cards always yields the largest
expected profit
However, it also appear to have a large standard
deviation (risk)

The Impact of Risk in
Our Decision
Producing 20,000 cards instead of 40,000, the
expected profits drop by about 22%, but the risk
drops almost 73%.
Therefore, if we are extremely risk averse,
producing 20,000 cards might be the right decision.
Note that producing 10,000 cards always has a
std.dev. of zero cards because if we produce 10,000
cards we will always sell all of them and have none
left over.


Confidence Interval for
Mean Profit
Into what interval are we 95% sure the true mean
will fall?
This interval is called the 95% confidence interval
for mean profit.
Its computed by the following formula:
Mean Profit (1.96*profit std.dev.)/(number iterations)
In our example: (53,650.46 59,628.26 )

Problems

1 A GMC dealer believes that demand for 2005
Envoys will normally be distributed with a mean of
200 and standard deviation of 30. His cost of
receiving an Envoy is $25,000, and he sells an
Envoy for $40,000. Half of all leftover Envoys can
be sold for $30,000. His is considering ordering
200, 220, 240, 260, 280, and 300 Envoys. How
many should he order?

Problems (cont.)
2 A small supermarket is trying to determine how
many copies of Newsweek magazine they should
order each week. They believe their demand for
Newsweek is governed by the following discrete
random variable


DEMAND PROBABILITY
15 0.10
20 0.20
25 0.30
30 0.25
35 0.15
Problems (cont.)

2 The supermarket pays $1.00 for each copy of
Newsweek and sells each copy for $1.95. They can
return each unsold copy of Newsweek for $0.50.
How many copies of Newsweek should the store
order to maximize its profit?
Part III: Advantages of
MCS
In conclusion, well discuss some advantages of
MCS over deterministic, or single-point estimate
analysis.

Advantages of MCS
MCS provides a number of advantages over
deterministic, or single-point estimate analysis:
Probabilistic Results
Graphical Results
Sensitivity Analysis
Scenario Analysis
Correlation of Inputs

Probabilistic Results

Results show not only what could happen, but how
likely each outcome is.

Graphical Results

Because of the data a Monte Carlo simulation
generates, its easy to create graphs of different
outcomes and their chances of occurrence.
This is important for communicating findings to
other stakeholders.

Sensitivity Analysis

With just a few cases, deterministic analysis makes
it difficult to see which variables impact the outcome
the most.
In Monte Carlo simulation, its easy to see which
inputs had the biggest effect on bottom-line results.

Scenario Analysis

In deterministic models, its very difficult to model
different combinations of values for different inputs
to see the effects of truly different scenarios.
Using Monte Carlo simulation, analysts can see
exactly which inputs had which values together
when certain outcomes occurred.
This is invaluable for pursuing further analysis.

Correlation of Inputs

In Monte Carlo simulation, its possible to model
interdependent relationships between input
variables.
Its important for accuracy to represent how, in
reality, when some factors go up, others go up or
down accordingly.
References

Wayne L. Winston, Microsoft Excel Data Analysis
and Business Modeling, 2004
http://office.microsoft.com/en-us/excel-
help/introduction-to-monte-carlo-simulation-
HA001111893.aspx
Monte Carlo Simulation
http://www.palisade.com/risk/monte_carlo_simulatio
n.asp