Financial Modeling

Risk Management – Simulation

Professor Iordanis Karagiannidis

© 2010 Iordanis Karagiannidis

Monte Carlo Simulation

 Monte Carlo Simulation is a tool that allows us to analyze

situations that are too complicated to model on a purely
theoretical example.

 Even if we know the exact probability distribution of all uncertain

parameters sometimes (most times) it is really hard to calculate
the distribution of the output variables

 Consider the Supreme Shoe example we did in class but now

assume that some variables are uncertain

© 2010 Iordanis Karagiannidis

Monte Carlo Simulation
 Simulation is like scenario analysis. The computer generates thousands of
different scenarios automatically

 When we don’t know or can’t calculate the theoretical distribution, we

can instead run an experiment.

 Each uncertain variable is assumed to be random with a known

probability distribution

 Key is to choose the correct probability distributions and correlation

structure for the variables

 After the experiment is completed we will have an approximation of the

distribution of the output variables

© 2010 Iordanis Karagiannidis

Steps in a Simulation
1) Selecting Uncertain Parameters
2) Selecting Probability Distributions
 Most of the important modeling decisions are made in steps 1 and 2,
selecting which variables to treat as random and which variables to treat
as nonrandom, and then, for the random variables, choosing appropriate
probability distributions.
3) Selecting Outputs
4) Running a Simulation
5) Analyzing Outputs

© 2010 Iordanis Karagiannidis

Selecting Uncertain Parameters

 It is worth running a sensitivity analysis on you basic spreadsheet

before determining which parameters you want to model as
uncertain.

 Only want to model important variables as random variables. For

the unimportant variables, not worth the expense.

 Decision variables should never be considered uncertain because

they are under our control. For example, on a make vs. buy
decision, don’t model the make vs. buy decision as random– you
are choosing it. Instead see how simulated outcome changes
under each decision separately.

© 2010 Iordanis Karagiannidis

Selecting Probability Distributions

 Have to select appropriate distribution (normal, lognormal, etc.),

plus the appropriate parameters.

 This step involves a good deal of judgment.

 Data analysis can be useful as well. Can use past outcomes to

predict probability of future outcomes. For example, might use
historical standard deviation of returns as your estimate of s.

© 2010 Iordanis Karagiannidis

Probability Distribution
 Describes the likelihood of different outcomes of a random
variable
 Discrete vs. Continuous Distributions

Discrete : Fixed number of Continuous: Infinite number

potential outcomes. (e.g. of potential outcomes. (e.g.
sum of two dice) time until machine fails)

 A continuous distribution is sometimes approximated by a discrete

distribution. The more potential outcomes, the closer the approximation.

© 2010 Iordanis Karagiannidis

 Discrete Distribution

 Expected Value    xi p( xi )
i

 Variance s 2

  p( xi ) xi   2

 For example, if possible stock returns and possibilities are:

E (r )  0.30  0.25  0.30  0.5  0.70  0.25  0.25

s r2  0.25  (0.30  0.40) 2  0.5  (0.30  0.40) 2  0.25  (0.70  0.40) 2  0.15

© 2010 Iordanis Karagiannidis

Continuous Distribution

 Expected Value    x p(x)dx


 Variance s2     2
p ( x )( x ) dx


 Where p(x) is the probability density function

 The most common continuous distributions is the Normal (or

Gaussian)
( x )2
1 
p( x)  e 2s 2

2s 2

© 2010 Iordanis Karagiannidis

Normal Distribution

© 2010 Iordanis Karagiannidis

Normal Distribution Examples

© 2010 Iordanis Karagiannidis

Back to the problem at hand

 Recall our question: what is the probability your portfolio (of one
stock) loses 50% or more of its value (and you get fired).

 For our example, let’s first assume the stock’s returns are
normally distributed to calculate the probabilities.

 Suppose your analysis suggests the stock has an annual expected

return [E(r)] of 20%. Also suppose the stock’s historical standard
deviation is 40%.

© 2010 Iordanis Karagiannidis

Calculating Normal Probabilities
 The probability of getting a return less than X is the area under
the normal probability curve from -∞ and up to point X
 Remember: We cannot calculate point probabilities for continuous
distributions

© 2010 Iordanis Karagiannidis

How do we calculate this?
 One way if to calculate the integral!

 Another way is to use excel’s NORM.DIST function

 NORM.DIST(X,MEAN,STDEV,TRUE)
 Calculates the area under the normal distribution curve we specify
and up to X
 In our example NORM.DIST(-50%,20%,40%,TRUE)=4.01%

 There is also the NORM.S.DIST function in Excel that calculates

probabilities based on the Standard Normal distribution

© 2010 Iordanis Karagiannidis

Reverse Problem
 Suppose again that returns are normally distributed with mean
20% and standard deviation 40%.

 Want an idea of how much cash is “at risk” at any given point in
time.

 What return can I expect to beat 99% of the time?

 Rephrased, what is the return I expect to lose more than only 1%

of the time?

© 2010 Iordanis Karagiannidis

Inverse cumulative normal density
function
 The cumulative normal density function, NORM.DIST(),
gave us a probability associated with any return.

 The inverse of this, the inverse cumulative normal density

function, NORM.INV(), does the reverse, gives us a return
associated with any probability.

 NORM.INV(probability, mean, std. dev.)

 NORM.INV(.01, 20%, 40%) = -73.05%

 You expect to lose 73.05% or more only 1 time in 100.

© 2010 Iordanis Karagiannidis

Value at Risk (VAR)
 We asked before what % I expected to lose only 1% of the time.

 Related Question: How much $ can I expect to lose only 1% of

the time?

 If the portfolio value is $100,000,000 this is

$100,000,000 * 73.05% = $73,000,000

 This is referred to as the Value at Risk (VAR) at 1%.

 VAR measures the worst expected loss under normal market

conditions over a specific time interval at a given confidence level

© 2010 Iordanis Karagiannidis

Value at Risk (VAR)
 VAR is a commonly used risk measure. Popularized by J P
Morgan.
 Widely used by banks to judge how much of their capital is at risk.
Looked at by regulators
 Frequently used by portfolio managers, particularly in hedge funds
or derivatives.
 Also used in some large industrial firms, particularly
multinationals, in risk management.
 1% level typically used by bank regulators, 5% typically used for
internal risk management.
 In our example, the VAR at 5% is $46,000,000
 For portfolio management, VAR is usually calculated over a much
shorter period than one year, typically one day.

© 2010 Iordanis Karagiannidis

Problem with Normal Distribution
 Suppose standard deviation is 90% instead of 40%, but E(r) is still
20%.
 What is probability of losing 50%?
 A: 21.83%
 What is probability of losing 110% or more?
 A: 7.43%
 We have a big problem here. Stock prices can’t go below zero!

 Use LogNormal Distribution

 Assume that the log(1+r) follows the Normal Distribution
 This means that 1+r follows the LogNormal with the same mean and
standard deviation
 We will look into this in detail later (equity modeling)

© 2010 Iordanis Karagiannidis