Posted by Harsimran Singh. on January 10, 2003 at 06:43:30:

Monte Carlo Simulation Model for Financial Modeling.

Simulation is an analytical method that tries to mimic a real-life system. Monte Carlo simulation gets its name after Monte Carlo in Monaco which is famous for its games of chance. Games of Chance such as roulette wheels, slot machines and dice exhibit what is termed random behaviour.

The random behaviour exhibited by games of chance is similar to the way a Monte Carlo simulation operates. When a dice is rolled, it is known that either 1, 2,3,4,5 or 6 will come up at least once, but it is not known at which roll of the dice any particular number will come up. Monte Carlo is a Simulation Model for computing the odds or probability of an outcome, such as the value of one’s retirement benefits at specified periods of time. This computation is arrived at by number crunching various permutation and combinations of the various variables in the situation.

Multiple Scenarios

A simulation, thus, calculates multiple scenarios by repeatedly inserting different sampling values from probability distribution for the uncertain variables into the computerized spread-sheet.

Certainty is the percentage probability or percentage chance that a particular forecast value will fall within a certain specified range.

A model can be defined as a type of spreadsheet that does more than simply organize data. It becomes a model only when the element of Analysis of data is inserted into the spread-sheet. Any spreadsheet can hold a variety of data, like inventory details, sales, purchases. But when a further element like a time-series program is added to the spread-sheet, which analyses the spread-sheet data in a desired manner, then the spread-sheet can be said to be a Model. A typical Model of this type can be an MS Excel Spreadsheet model with a time series program.

Monte Carlo Simulation is of use in Financial Planning and Risk Assessment. But such Simulation Models can work usefully only if-
1. A clearly defined purpose for the modeling study is a pre-requisite.
2. Financial Modeling is an art. The user has to know what to include and what to exclude.
3. Financial Models are only as good as the Assumptions on which they are based.
4. As the article titled “A Better way to size up your Nest Egg” in Business week Online (January 22, 2001) pointed out, a Monte Carlo Simulation with 500-1000 events would not have generated the scenario of the stock-market crash of 1987. The program would have needed 100,000 or more simulations to come up with that particular extra-ordinary event.
5. A Monte Carlo Simulation can never take the place of Certainty. It can only give a Probability Test. It can model what may happen, not what will happen.

Conclusion

Monte Carlo Simulation is a valuable modeling tool that generates multiple scenarios depending upon the data and the assumptions fed into the model. It is an invaluable aid for Risk Analysis and Risk Management Handled properly, with relevant data and relevant assumptions; it can make decision making an informed and logical process.

Harsimran Singh.

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Follow Ups:

• Re: Monte Carlo Simulation for Financial Modeling. uday kumar ghosh. 07:32:21 01/10/03 (0)

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