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Lecture 02 Simulation and Modeling

Simulation and modeling

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23 views8 pages

Lecture 02 Simulation and Modeling

Simulation and modeling

Uploaded by

tasifxamal5295
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Monte Carlo Simulation: What It Is, How It

Works, Applications, Key Steps

Key Takeaways
● A Monte Carlo simulation is a model used to predict the probability of
a variety of outcomes when the potential for random variables is
present.
● Monte Carlo simulations help to explain the impact of risk and
uncertainty in prediction and forecasting models.
● A Monte Carlo simulation requires assigning multiple values to an
uncertain variable to achieve multiple results and then averaging the
results to obtain an estimate.
● These simulations assume perfectly efficient markets.
● Monte Carlo simulations are increasingly used in conjunction with
artificial intelligence.

How the Monte Carlo Simulation Assesses Risk


When faced with significant uncertainty in making a forecast or estimate,
some methods replace the uncertain variable with a single average number.
The Monte Carlo simulation instead uses multiple values and then averages
the results.

Applications of Monte Carlo Simulation


Monte Carlo simulations have a vast array of applications in fields that are
plagued by random variables, notably business and investing. They are used
to estimate the probability of cost overruns in large projects and the likelihood
that an asset price will move in a certain way.

Telecoms use them to assess network performance in various scenarios,


which helps them to optimize their networks. Insurers use them to measure
the risks they may be taking on and to price their policies accordingly.
Investment analysts use Monte Carlo simulations to assess the risk that an
entity will default, and to analyze derivatives such as options. Financial
planners can use them to predict the likelihood that a client will run out of
money in retirement.1

Monte Carlo simulations also have many applications outside of business


and finance, such as in meteorology, astronomy, and physics.

Today, Monte Carlo simulations are increasingly being used in conjunction


with new artificial intelligence (AI) models. For example, as IBM noted in
2024, many financial firms now use high performance computing systems to
run Monte Carlo simulations and, "As the numbers of these simulations grow
over ever-increasing portfolios of financial assets and instruments, the
interpretation of these as an entirety becomes a growing challenge." That is
where AI comes in. "The use of AI to assist a professional in their
assessment of these simulations can both improve accuracy as well as
deliver more timely insights. In a business where time-to-market is a key
differentiator, this has direct business value," IBM says.2

How Monte Carlo Simulations Work


The Monte Carlo method acknowledges an issue for any simulation
technique: The probability of varying outcomes cannot be firmly pinpointed
because of random variable interference. Therefore, a Monte Carlo
simulation focuses on constantly repeating random samples.

A Monte Carlo simulation takes the variable that has uncertainty and assigns
it a random value. The model is then run, and a result is provided. This
process is repeated again and again while assigning many different values
to the variable in question. Once the simulation is complete, the results are
averaged to arrive at an estimate.

The 4 Steps in a Monte Carlo Simulation


To perform a Monte Carlo simulation, there are four main steps. As an
example, Microsoft Excel or a similar program can be used to create a Monte
Carlo simulation that estimates the probable price movements of stocks or
other assets.

There are two components to an asset's price movement: drift, which is its
constant directional movement, and a random input, which represents
market volatility.

By analyzing historical price data, you can determine the drift, standard
deviation, variance, and average price movement of a security. These are
the building blocks of a Monte Carlo simulation.

The four steps are as follows:


Step 1. To project one possible price trajectory, use the historical price data
of the asset to generate a series of periodic daily returns using the natural
logarithm (note that this equation differs from the usual percentage change
formula):

Step 2. Next, use the AVERAGE, STDEV.P, and VAR.P functions on the
entire resulting series to obtain the average daily return, standard deviation,
and variance inputs, respectively. The drift is equal to:

Alternatively, drift can be set to 0; this choice reflects a certain theoretical


orientation, but the difference will not be huge, at least for shorter time
frames.

Step 3. Next, obtain a random input:


The equation for the following day's price is:

Step 4. To take e to a given power x in Excel, use the EXP function: EXP(x).
Repeat this calculation the desired number of times. (Each repetition
represents one day.) The result is a simulation of the asset's future price
movement.

By generating an arbitrary number of simulations, you can assess the


probability that a security's price will follow a given trajectory.
How Is the Monte Carlo Simulation Used in Finance?
A Monte Carlo simulation is used to estimate the probability of a certain
outcome. As such, it is widely used by investors and financial analysts to
evaluate the probable success of investments they're considering. Some
common uses include:

● Pricing stock options: The potential price movements of the


underlying asset are tracked given every possible variable. The results
are averaged and then discounted to the asset's current price. This is
intended to indicate the probable payoff of the options.
● Portfolio valuation: A number of alternative portfolios can be tested
using the Monte Carlo simulation in order to arrive at a measure of
their comparative risk.
● Fixed-income investments: The short rate is the random variable
here. The simulation is used to calculate the probable impact of
movements in the short rate on fixed-income investments, such as
bonds.

What Professions Use the Monte Carlo Simulation?


It may be best known for its financial applications, but the Monte Carlo
simulation is used in virtually every profession that must measure risks and
prepare to meet them.

For example, a telecommunications company may build its network to


sustain all of its users all of the time. To do that, it must consider all of the
possible variations in demand for the service. It must determine whether the
system will stand the strain of peak hours and peak seasons.

A Monte Carlo simulation may help the company decide whether its service
is likely to stand the strain of a Super Bowl Sunday as well as an average
Sunday in August.

What Factors Are Evaluated in a Monte Carlo


Simulation?
A Monte Carlo simulation in investing is based on historical price data for the
asset or assets being evaluated.

The building blocks of the simulation, derived from the historical data, are
drift, standard deviation, variance, and average price movement.

The Bottom Line


The Monte Carlo simulation shows the spectrum of probable outcomes for
an uncertain scenario. This technique assigns multiple values to uncertain
variables, obtains multiple results, and then takes the average of these
results to arrive at an estimate.

From investing to engineering, the Monte Carlo method is used in many


fields to measure risk, including estimating the likelihood of a gain or loss in
an investment, or the odds that a project will run over budget

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