Monte Carlo Simulation: Monte Carlo simulation is named after the city in Monaco, where the primary attractions

are casinos that have games of chance. Gambling games, like roulette, dice, and slot machines, exhibit random behavior. In finance, there is a fair amount of uncertainty and risk involved with estimating the future value of figures or amounts due to the wide variety of potential outcomes. Monte Carlo simulation (MCS) is one technique that helps to reduce the uncertainty involved in estimating future outcomes. MCS can be applied to complex, non-linear models or used to evaluate the accuracy and performance of other models. It can also be implemented in risk management, portfolio management, pricing derivatives, strategic planning, project planning, cost modeling and other fields. Basic Characteristics MCS allows several inputs to be used at the same time to create the probability distribution of one or more outputs.
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Different types of probability distributions can be assigned to the inputs of the model. When the distribution is unknown, the one that represents the best fit could be chosen.

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The use of random numbers characterizes MCS as a stochastic method. The random numbers have to be independent; no correlation should exist between them.

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MCS generates the output as a range instead of a fixed value and shows how likely the output value is to occur in the range.

Some Frequently Used Probability Distributions in MCS

Normal/Gaussian Distribution - Continuous distribution applied in situations where the mean and the standard deviation are given and the mean represents the most probable value of the variable. It is symmetrical around the mean and is not bounded. Lognormal Distribution - Continuous distribution specified by mean and standard deviation. This is appropriate for a variable ranging from zero to infinity, with positive skewness and with normally distributed natural logarithm.

. determining its susceptibility to different kinds of risk (such as interest rate changes and exchange rate fluctuations). It is bounded by the minimum and maximum values and can be either symmetrical (the most probable value = mean = median) or asymmetrical. and to analyse various notions and measures of risk. Many companies use Monte Carlo simulation as an important tool for decision-making. provided the rate of occurrences is known. they are used to value derivatives by simulating the random changes in the underlying assets upon which those derivatives are based.Continuous distribution used to illustrate the time between independent occurrences. Procter and Gamble. the techniques have become widespread. In finance. Monte Carlo simulation is the only feasible valuation technique. At GM. Indeed. Wall Street firms use simulation to price complex financial derivatives and determine the Value at RISK (VAR) of their investment portfolios. y GM uses simulation for activities such as forecasting net income for the corporation. y y Lilly uses simulation to determine the optimal plant capacity that should be built for each drug. this information is used by CEO Rick Waggoner to determine the products that come to market. Uniform Distribution . Exponential Distribution .Triangular Distribution .Continuous distribution bounded by known minimum and maximum values. Monte Carlo methods are widely used in many areas of mathematics and science. for many derivatives. Who uses Monte Carlo simulation? Today. since then. predicting structural costs and purchasing costs. and Eli Lilly use simulation to estimate both the average return and the riskiness of new products. The first time such a simulation was used in a derivative valuation was in 1977 [2] and. the likelihood of occurrence of the values between the minimum and maximum is the same. Here are some examples. y General Motors. In contrast to the triangular distribution.Continuous distribution with fixed minimum and maximum values.

and percentiles.uk/montecarlo/concept.y y Procter and Gamble uses simulation to model and optimally hedge foreign exchange risk. C++. y Financial planners use Monte Carlo simulation to determine optimal investment strategies for their clients retirement.html#What_Knowledge_Do_I_Need_to_Use_It http://www. contract.asp http://office. you must be able to build a quantitative model of your business activity. What Knowledge Do I Need to Use It? To use Monte Carlo simulation. Sears uses simulation to determine how many units of each product line should be ordered from suppliers for example." such as the value of an option to expand. you'll use statistics such as the mean.with functions that draw random samples from probability distributions.for example in spreadsheet cells -.co. or postpone a project.aspx http://www.or using a special-purpose simulation modeling language. plan or process.com/simulation/monte-carlosimulation/index.investopedia. there are great software tools (like ours!) to help you do this.with Frontline's Solver Platform SDK -.and use Frontline Systems' Risk Solver as a simulation tool. One of the easiest and most popular ways to do this is to create a spreadsheet model using Microsoft Excel -. backed by technical support and assistance. http://www.microsoft.com/en-us/excel-help/introduction-to-monte-carlo-simulationHA001111893. you'll replace certain fixed numbers -. Other ways include writing code in a programming language such as Visual Basic. how many pairs of Dockers should be ordered this year. as well as charts and graphs.brighton-webs.You'll also need to learn (or review) the basics of probability and statistics.asp . standard deviation. And to analyze the results of a simulation run. Fortunately.com/articles/07/monte_carlo_intro. To deal with uncertainties in your model.solver. C# or Java -. y Simulation can be used to value "real options.

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