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Simulation: An Application in Finance

This document discusses simulation and the Monte Carlo method for applications in finance. It describes how simulation can be used to model potential outcomes of alternative decisions by accounting for random variables. The Monte Carlo method specifically involves statistically sampling potential values and calculating average results. As an example, it outlines a process for using Monte Carlo simulation to model the net present value of a project based on random annual cash flows and project lifetimes.

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43 views9 pages

Simulation: An Application in Finance

This document discusses simulation and the Monte Carlo method for applications in finance. It describes how simulation can be used to model potential outcomes of alternative decisions by accounting for random variables. The Monte Carlo method specifically involves statistically sampling potential values and calculating average results. As an example, it outlines a process for using Monte Carlo simulation to model the net present value of a project based on random annual cash flows and project lifetimes.

Uploaded by

knowledgequest
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Simulation

An Application in Finance
INTRODUCTION :
Simulation is the imitation of some real thing, state
of affairs, or process. The act of simulating something
generally entails representing certain key
characteristics or behaviours of a selected physical or
abstract system.
NEED FOR SIMULATION
Simulation can be used to show the eventual real
effects of alternative conditions and courses of action.
Simulation is also used when the real system cannot be
engaged, because it may not be accessible, or it may be
dangerous or unacceptable to engage, or it is being
designed but not yet built, or it may simply not exist [2].
MONTE CARLO METHOD
The Monte Carlo Method encompasses any technique
of statistical sampling employed to approximate
solutions to quantitative problems. Essentially, the
Monte Carlo method solves a problem by directly
simulating the underlying (physical) process and then
calculating the (average) result of the process.
Procedure
Model the project
Specify the value of parameters and the probability
distribution of the exogenous variables.
Select a value at random
Determine the net present value from generated value
Plot the frequency distribution of NPV.
ANNUAL CASH FLOW PROJECT LIFE
 VALUE PROB. VALUE PROB.
 1000 .02 3 YEARS .05
 1500 .03 4 .10
 2000 .15 5 .30
 2500 .15 6 .25
 3000 .30 7 .15
 3500 .20 8 .10
 4000 .15 9 .03
10 02
Correspondence b/w value of exogenous and two
digit random number

Annual cash flow Project life


 Value prob. C.prob. Ran.n Value prob. C.prob. Ran.n
 1000 .02 .02 00to 01 3years .05 .05 00to04
 1500 .03 .05 02to04 4 .10 .15 05to14
 2000 .15 .20 05to19 5 .30 .45 15to44
 2500 .30 .50 20to34 6 .25 .70 45to69
 3000 .30 .80 35to64 7 .15 .85 70to84
 3500 .20 .85 65to84 8 .10 .95 85to94
 4000 .15 1.0 86to99 9 .03 .98 95to97
10 .02 1.0 98to99
Simulation Result
Run ran.no. A.C.F. Ran.no. V.p.l. NPV
1 53 3000 97 9 4277
2 66 3500 99 10 8506
3 30 2500 81 7 829
4 19 2000 09 4 7660
5 31 2500 67 6 2112
Evaluation :
Advantages Disadvantages
 Versatility Difficult
 Explicitly consider the Inherently imprecise
interdependencies. Complex

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