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You are on page 1of 75

Kipp Martin

University of Chicago

Booth School of Business

November 5, 2015

Reading:

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directory that was installed with your software.

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retirement.xlsx

retirementRisk.xlsx

retirementRiskGoal.xlsx

Learning Objectives

1. Understand why stochastic models are important

2. Understand the Flaw of Averages

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Lecture Outline

After installing the Precision Tools Suite:

1. Click on the @RISK icon on your desktop

2. Use AddIns to put @RISK on the Ribbon for future use.

From now on, you can open Excel and do not need to use the desktop

icons. You should see Tab items for both PrecisionTree and @Risk.

Tips:

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Tips: Mac User Setting for VM Ware

The natural progression of modeling:

certainty

and variances of a statistical distribution

statistical distribution)

We are taking tools from earlier in the quarter and extending them to

allow for stochastic parameters.

Deterministic Tool

Goal Seek

Data Table

Solver

Stochastic Tool

@Risk Goal Seek (Week 7)

@Risk RiskSimtable (Week 8)

@Risk Optimizer (Week 10)

and stochastic model.

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If there are numbers in your spreadsheet that are not known with

certainty, putting in estimated average values can lead to terrible

results!

With @RISK we will enter distributions rather than numbers into cells.

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You want to withdraw equal amounts for the next 20 years until the fund

is depleted.

How much can you withdraw each year before hitting 0 at the end of year

20?

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In Workbook retirement.xlsx there are two spreadsheets:

S&P 500: this spreadsheet has the S&P returns for 1926-2012.

This also has the calculations:

1. mean = 0.115486207

A Few Things:

2. I am using annual compounding.

3. You may wish to use continuous compounding.

4. With continuous compounding, the arithmetic and geometric mean

the same.

5. Using continuous does not affect the result I am demonstrating.

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Take a first cut using the PMT function in Excel. See cell B6, it has

range name payment.

There are five arguments:

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at the beginning of the period

fv the future value what you want to end up with after all the

payments are made, in our case 0

the beginning, the value is 0 if this argument is omitted

=PMT(interest_rate,years,-savings,0,1)

PMT(.1155, 20, -200000, 0, 1)

The value is $23,327.72

If you take out $23,327.72, while earning 11.55% on your money each

year, you will drawn the account down to 0 at the end of 20 years.

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See the spreadsheet retirement.xls.

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See the spreadsheet retirement.xls.

The key formulas are in columns B and E. For example, in cell B14 we

have

E13

This says that the amount of money at the start of year 3 is equal to the

amount of money at the end of year 2.

In cell E14 we have

=IF(D14 > B14, 0, (1 + C14)*(B14-D14))

In the formula above we are saying that if the withdrawal amount is less

than what we have in the account, the amount in the account at the end

of the year is the beginning balance minus the withdrawal times (1 +

return).

In this analysis we assume that the S&P return is a constant 11.55% per

year.

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In the spreadsheet retirement.xls we make calculations based on the

average interest rate. Everything is deterministic!

with a mean of 11.55% and standard deviation of 20.62%. We simulate

reality.

Dont worry about how to generate random interest rates for now.

Argle Bargle!!! I am out of money after only five years! Handout anyone?

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What! Now I die with $561,151 left unspent. That is NOT fair!

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Argle Bargle!!! Out of money yet again.

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Living a thousand lives. Distribution of years.

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Living a thousand lives, cumulative probabilities.

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YouTube link

http://www.youtube.com/watch?v=Oah03QcRxGY

This lecture is best summed up by the pictures on the following slides.

The first picture was shamelessly stolen from the Web site of Sam

Savage. But Sam is a nice guy and probably will not sue me.

The second picture was from the San Jose Mercury Times. Hopefully

they wont sue either.

http://www.analycorp.com/uncertainty/flawarticle.htm

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The bottom line the average can be pretty useless!

A second rule of thumb:

The more nonlinear the problem, the worse our results will be by using

average values. Here is the problem:

E (f (X )) 6= f (E (X ))

When you put average values into the cells (i.e. E (X )) you are

calculating f (E (X )) but you really want E (f (X )).

What is X in our retirement example?

What is f (X ) in our case?

Warning: f (X ) is a real ARGLE BARGLE!

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In our case, f (X ) is

COUNTIF(E12:E31,">0")

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The Trace Precedents for f (X )!

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Here is a good example to help your intuition on why

E (f (X )) 6= f (E (X ))

Consider a random variable X that can take on two values: the two

values are X = 1 and X = 1 (the market is either up or down).

Assume each event is equally likely and so the probabilities are:

p(X = 1) = .5 and p(X = 1) = .5.

The function of interest is: f (X ) = max(0, X ).

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What is f (E (X ))?

What is E (f (X ))?

What is f (E (X ))?

E (X ) = 1 .5 1 5 = 0

f (E (X )) = f (0) = max(0, 0) = 0

What is E (f (X ))?

E (f (X )) = .5 max(0, 1) + .5 max(0, 1) = .5 1 + .5 0 = .5

E (f (X )) 6= f (E (X ))

Remember: A linear life is a good life. Some bad functions:

IF

MAX, MIN

COUNTIF

Before you took this course, you probably thought the IF function in Excel

was pretty nice. Little did you know of the dangers that lurked below.

Simulation Basics

The histograms on the previous slides result from drawing rates of

return from a statistical distribution.

What does drawing a rate of return mean?

First, some definitions.

A random variable, X, is a function that maps each element in the

outcome space to a real number.

Example 1: Coin Toss think of the outcome space as {H, T } (a head

(H) or a tail (T)). The random variable X maps, for example, X (H) = 0

and X (T ) = 1.

Example 2: S&P 500 Return think of the outcome space as all

possible corporate earnings, market interest rates, etc. The random

variable X assigns a return for the S&P index for each possible element

in the outcome space.

Simulation Basics

A probability density function (pdf) assigns a probability to each

outcome.

Example 1: Coin Toss p(X = 0) = 0.5 and p(X = 1) = 0.5

Example 2: S&P 500 Return Assuming returns for the S&P 500 index

are normally distributed (mean .1155 and standard deviation .2062) what

is the probability

.1155 .2062 X .1155 + .2062 = .6826

Assuming returns for the S&P 500 index are normally distributed (mean

.1155 and standard deviation .2062) what is the probability

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Simulation Basics

Here is the normal probability density function (pdf).

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Simulation Basics

Here is the normal cumulative density function (cdf).

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Simulation Basics

For any random variable, the cumulative density functions (CDF) is

between 0 and 1.

If the horizontal axis is r , the cdf is a plot of p(X r ) versus r , with

p(X r ) on the vertical axis.

Excel has a RAND() function (note there are no arguments for this

function).

In retirement.xlsx, in cell A1, type in =RAND(). Now either:

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group hit Calculate Now.

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Simulation Basics

The Excel RAND() generates a uniformly distributed random number

between 0 and 1.

A random number can be used to randomly draw an S&P 500 rate of

return.

Associate each with random number between 0 and 1 with a point on the

vertical axis of the S&P 500 CDF function.

Use the associated value on the horizontal axis as the rate of return.

For example,

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0.16774

-0.22367

Simulation Basics

Here is the normal cumulative density function (cdf).

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Simulation Basics

So, are we going to use the RAND() function to generate a random

number between 0 and 1 and then do a lookup?

convenient.

simulates life in retirement.

Simulation Basics

In the following slides we take the workbook retirement.xlsx and

create the content in workbook retirementRisk.xlsx.

Step 1: use the Excel function COUNTIF.

Put the formula

=COUNTIF(E12:E31,">0")

in cell E32.

This will count the number of years where we end the year with a

positive amount of money.

Objective: run a 1000 trials and see the behavior of this number.

44

Simulation Basics

Step 2 Incorporate Uncertainty: Here is how we incorporate

uncertainty.

We were using average values for the rates of return. This changes.

Select Cell C12 and then Define Distribution from the Model

group. See next slide.

Simulation Basics

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Simulation Basics

When you click on Define Distribution you will see:

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Simulation Basics

Put in the mean and standard deviation.

We could have used the range names mean and std.

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Simulation Basics

include:

Simulation Basics

Step 3: Copy Cell C12 and paste it to Cells C13 to C31.

Formulas). We make a draw of a rate of return from the normal

distribution with mean .1155 and standard deviation .2062 for cells C12 C31.

These draws are all independent of each other. That is, they are not

correlated. More on this topic later.

Make the font in cells C12 - C31 magenta. We are going to make our

uncertain parameter cells magenta. I am open to other color selections.

Simulation Basics

Step 4: Now, back to Cell E32. This is the cell we care about. It is

telling how many years we end with a positive amount of money (a good

thing).

Key Idea: Cell E32 is really a random variable. Its value depends on

other random variables.

We tell @RISK to consider Cell E32 an output cell. See next slide.

Simulation Basics

Select Cell E32 and then click Add Output from the Model group.

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Simulation Basics

=RiskOutput()+COUNTIF(E12:E31,">0")

@RISK will now treat Cell E32 as a random variable and generate

probability distribution information for the cell output.

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Simulation Basics

Step 5: Run the simulation!

My default is set for a 1000 trials. Dont worry about how many trials for

now.

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Simulation Basics

Step 5: Examine the output for Cell E32.

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Simulation Basics

Here is the cumulative histogram.

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Simulation Basics

How to stop the simulation.

What to do if your simulation seems to be taking too long.

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Simulation Basics

You can adjust the tails of the histogram by dragging or tying in the tail

value you care about.

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Simulation Basics

Other Hints:

1. The simulation will run much faster if you turn demo off.

2. I recommend you turn on Automatically Show Output Graph.

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Simulation Basics

Sample Exam Question 1: In the retirement example, what is f(E(X))

when the payment is $23,327.72 and

payment is $23,327.72 and

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Simulation Basics

The bottom line using averages can lead to bad results when the

standard deviation is large!

A rule of thumb:

The greater the variance, the worse our results will be by using

average values.

The average high temperature for Chicago on April 1 is 53 degrees.

Conclusion: If I wear a light jacket walking to the Harper Center I

will be comfortable.

The average high temperature for Honolulu on April 1 is 82 degrees.

Conclusion: If I wear a tee shirt and jeans I will be comfortable.

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Simulation Basics

The bottom line using averages can lead to bad results when the

standard deviation is large!

Running

Back 1

4.0

0.3

Std. Dev.

Running

Back 2

4.5

2.5

Which back should carry?

Situation 2: Own 20, down by 1 point, 5 minutes left in fourth quarter.

Which back should carry?

62

Simulation Basics

Summary:

Simulation Basics

Color Coding:

as such)

distribution

using Goal Seek or RiskSimtable()

Output)

If we withdraw $23,327.72 per year, on average, it will last 14.42 years.

Not very satisfying.

Even worse, there was a draw of only 3 years.

Let turn the question around and see how much we can take out each

year, and have a minimum draw of 18.

In @RISK there is a Goal Seek very similar to the Excel Goal Seek we

used earlier in the quarter.

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The Goal cell is E32. This is the cell that counts the number of periods

with a positive amount of money.

We are interested in recording the minimum number of years for this cell.

We change cell B6 which is the amount of money we withdraw each year.

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Notice we are restricting our search to be between 0 dollars and 25000

dollars.

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We should withdraw $4,389.86. Notice we did only 100 simulations per

iteration. This should probably be larger.

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Note: If you did not invest in the market, and got a 0 percent rate of

return each year, you could withdraw $10,000 a year and die with zero

dollars left.

allocate your money between the stock market and a less risky asset.

Summary

Running a simulation creates a histogram for each cell in the spreadsheet

that contains a RiskOutput(). You can have @RISK put the summary

statistics from the simulation directly in the spreadsheet.

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Summary

You can insert functions with Insert Function, Statistic Functions,

then Simulation Result.

71

Summary

See the workbook retirementRisk.

After running a new simulation, these cells will hold, respectively, the

simulation sample mean and variance.

=RiskOutput()+COUNTIF(E12:E31,">0").

Summary

What we are doing is called Monte Carlo Simulation. The process was

developed by Stanislaw Ulam and Nicholas Metropolis.

Process developed while working on nuclear weapons projects at Los

Alamos. Named after Monte Carlo where Ulams uncle often gambled.

Building a Monte Carlo Simulation Model:

1. Identify model inputs:

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3. Identify model outputs (green cells)

4. Run the simulation

5. Analyze the outputs

Summary

2012 SABR (Society for American Baseball Research) Competition.

http://sabr.org/analytics/case/2012

One of the things that distinguished the Booth (presentation) was their

outstanding use of risk analysis, particularly their Monte Carlo

simulations on playoff probabilities and (looking at) some of the other

considerations that weighed into their decision, Gennaro (society

president) said.

74

Summary

Deja Vu all over again.

useful. Why?

75

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