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Simulation Modeling

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Choosing Probability Distributions

Simulation models generate random inputs that are assumed to follow a
probability distribution.
C C (1 r )
1

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Random Variable
r N (, 2 )

Choosing Probability Distributions

There are four ways of choosing a probability distribution for a simulation model,
including:
1. Bootstrapping technique: examines probability distributions of historical returns and
assumes future returns will follow the same distribution. Future ending scenarios are
simulated by randomly drawing from historical scenarios of past returns.
2. Parameter estimate technique: uses parameters to define the shape of a specific
probability distribution for future input variables. Historical data is used to estimate
parameters required for the future distribution. For example, the mean () and standard
deviation () are parameters for a normal probability distribution, is the parameter for a
Poisson distribution.
3. Best fit technique: finds a probability distribution that best fits historical data.
4. Subjective guess technique: constructs a future probability distribution based on a
subjective guess of how an input variable will behave in the future. This method is not
based on historical data. For example, if you have a pessimistic () view of future
returns, you might use the beta distribution with a probability distribution mass that is
skewed more to the left than the normal distribution.
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Monte Carlo Simulation

assume we invest \$100 today in the S&P 500 index for one year. Also assume
that the return over the next year, r , follows a normal distribution. In this case,
we could use historical data to estimate the mean and standard deviation for the
normal distribution. These parameter estimates will fluctuate depending on the
chosen time period. Lets assume that the historical mean return of the S&P 500
is 10%, and the standard deviation is 15%.
To estimate capital at the end of year one, C1, we can run a simulation drawing
100 random returns from a normal distribution with a mean of 10% and a
standard deviation of 15%. The simulation output generates 100 ending capital
amounts based on the formula C1 = C0 (1 + r). If next years return follows
historical returns, then, on average, you would expect to have an ending capital
amount of \$110.

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Monte Carlo Simulation

Example: what is the 95% confidence interval for the ending capital amount from
a simulation run where the number of simulations is 100 (N=100), the mean
ending capital, ( X ), is \$110.009, and the standard deviation, s, is \$14.798?
\$14.798
\$14.798

\$110.009

1.98

,
\$110.009

1.98

\$107.079, \$112.939
100
100

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The four major advantages of simulation modeling when multiple input variables and
compounding distributions () are involved are as follows:
1. Simulation models simplify complex functions because the probability distribution of the
output variable does not need to be identified. When more complex functions are
involved, it is very difficult to derive the probability distribution of the output variable
based on the probability distributions of the input variables. For example, the ending
capital output is normally distributed for a one-period model assuming the input returns
are normally distributed. However, with multiple periods, the output distribution is not
known.
2. Simulation models create visible output probability distributions that can be analyzed
when compounding probability distributions result from multiple input variables.
3. Simulation models allow for correlations between input variables.

4. Simulation models can easily examine effects on output variables when changing
strategies or scenarios.

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Example: Incorporating multiple input variables into simulations
Suppose that we invest \$100 in the S&P 500 index for 30 years instead of just one year.
We assume the annual returns over the next 30 years follow a normal distribution with a
mean of 10% and a standard deviation of 15%. Will the probability distribution of capital
at the end of 30 years be normally distributed?

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Incorporating Correlations Into Simulation Modeling

Example: Suppose that we invest \$50 in the S&P 500 index and \$50 in Treasury bonds for 30
years. For the S&P 500 index, we assume the annual returns over the next 30 years follow a
normal distribution with a mean of 10% and a standard deviation of 15%. Treasury bonds are
assumed to following a normal distribution with a mean of 4% and a standard deviation of 7%.
We assume correlation is -0.2. Thus the returns of S&P 500 index and Treasury bonds index

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201405

69. A quantitative analyst used a simulation to forecast the S&P 500 index value at the end of the
year with an index value of 1,800 at the beginning of the year. He generated 200 scenarios and
calculated the average index value at year-end to be 1,980, with a 95% confidence interval of
[1,940, 2,020]. In order to improve the accuracy of the forecast, the quantitative analyst
increased the number of scenarios to attain a new 95% confidence interval of [1,970, 1,990]
with the same sample mean and the same sample standard deviation. How many scenarios
were used to generate this result?
s
s
A. 400
1980+1.645
2020 1.645
40
200
200
B. 800
s
s
C. 1,600
1980+1.645
1990 1.645
10
N
N
D. 3,200
N 3200

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Estimator Bias

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201405
32.A quantitative risk analyst is comparing the computational efficiency of different
estimators generated using Monte Carlo simulation. Relevant information is
summarized in the following table:
Standard Deviation
Time for generating one
scenario (seconds)
Scenarios
Total time for generating
scenarios (seconds)

Estimator A
0.30
35

Estimator B
0.40
25

Estimator C
0.25
40

Estimator D
0.35
30

20
700

40
1,000

30
1,200

50
1,500

which of the estimators is most computationally efficient?

s1 1 A 0.30 700 7.9373
A. Estimator A
B. Estimator B
s2 2 B 0.40 1000 12.6491
C. Estimator C
s3 3 C 0.25 1200 8.6603
D. Estimator D
s4 4 D 0.35 1500 13.5554

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Creating Random Numbers

Inverse transform method
X~U[0,1] x N ( y) y N 1 ( x)

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Pseudorandom Number () Generators

Midsquare technique ()
was one of the first pseudorandom number generators. The sequence from this
technique is created by squaring the first random number (i.e., the seed) and using the

set of middle digits for the next random number.

Take a seed, square it and use the set of middle digits as the next random number. For
example:

95512=91221601; middle four digits=2216; random number=0.2216

This random number sequence continues using the same midsquare technique. Eventually,
the middle digits become a small number such as 1 or 0, and the sequence converges and
generates the same numbers over and over again. Therefore, this technique can result in a
very short cycle of random numbers.

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Example
1.

What is the first random number in a sequence of random numbers between 0

and 1 that is created using the midsquare technique with a seed number of
4931?

A. 0.3147
B. 0.4852
C. 0.6931

D. 0.9246

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Pseudorandom Number () Generators

Congruential pseudorandom number generators (
). A more effective technique that avoids the short cycle problem of the midsquare
technique.

A x n 1
x n A x n 1 m

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Stratified Sampling Method

The stratified sampling method can also be used with more than one variable or
dimension. For example, the Latin Hypercube () Sampling
method is a p-dimensional model instead of a linear interval from [0,1].

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Example
2.

An analyst is running a Monte Carlo simulation to estimate the ending amount of

capital in 20 years based on monthly returns for three investments. Two of these
investments are highly correlated, and one has a correlation close to zero with the
other two investments. In order to properly analyze Monte Carlo simulation output
for this problem, the analyst:
A. must carefully determine the probability distribution of the output ending
capital.
B. can easily examine effects on output variables when changing scenarios.
C. must assume that the probability distribution for the output ending capital is
normally distributed if the monthly returns are assumed to be normally
distributed.
D. cannot control for correlations between the three investments.

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Example
3.

The 95% confidence interval for the output of ending capital is calculated to be
(\$117.03, \$122.97) for a simulation run with 100 scenarios. In addition, the
simulation resulted in a mean ending capital amount of \$120 with a standard
deviation of \$15. Suppose we want to improve the accuracy of this confidence
interval by running a simulation of 400 scenarios. What is the new 95%
confidence interval with a simulation of 400 scenarios using the same mean and
standard deviations from the model with 100 scenarios?
A.

(\$117.23, \$122.95).

B.

(\$118.52, \$121.48).

C.

(\$119.02, \$121.99).

D.

(\$119.71, \$122.27).

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Example
4.

Suppose you run a simulation to estimate the output of ending wealth for an
investment of \$100,000 today over a 30-year time period using random monthly
returns that are assumed to be normally distributed. How does this action create a
discretization error bias?
A. The true probability of the input random returns is unknown and creates the
bias.
B. The true probability of the output ending wealth is unknown and creates the
bias.
C. The assumption that returns are random creates the bias.
D. The assumption that returns occur on a monthly basis in the model instead of
continuously creates the bias.

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Example
5.

Monte Carlo simulation is that:
A.

B.

C.

D.

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