Monte Carlo Simulation

Natalia A. Humphreys April 6, 2012 University of Texas at Dallas

Aknowledgement
Wayne L. Winston, Microsoft Excel Data Analysis

and Business Modeling, 2004

Overview
Part I
Questions answered with the help of MCS History Typical simulations

Part II: Simulation examples Part III: Advantages of MCS over deterministic

analysis

Challenges
We are constantly faced with uncertainty, ambiguity,

and variability.
Risk analysis is part of every decision we make.

Wed like to accurately predict (estimate) the

probabilities of uncertain events.

Monte Carlo simulation enables us to model

situations that present uncertainty and play them out thousands of times on a computer.

Questions answered with the help of MCS

How should a greeting card company determine

how many cards to produce?

How should a car dealership determine how many

cars to order?
What is the probability that a new products cash

flows will have a positive net present value (NPV)?

What is the riskiness of an investment portfolio?

Modeling with MCS

Monte Carlo Simulation (MCS) lets you see all the

possible outcomes of your decisions and assess the impact of risk, allowing for better decision making under uncertainty.

MCS: Where did the Name Come From?

During the 1930s and 1940s, many computer

simulations were performed to estimate the probability that the chain reaction needed for the atom bomb would work successfully.
The Monte Carlo method was coined then by the

physicists John von Neumann, Stanislaw Ulam and Nicholas Metropolis, while they were working on this and other nuclear weapon projects (Manhattan Project) in the Los Alamos National Laboratory.
It was named in homage to the Monte Carlo Casino, a

famous casino in the Monaco resort Monte Carlo where Ulam's uncle would often gamble away his money.

Who Uses MCS?

General Motors (GM) Procter and Gamble (P&G) Eli Lilly Wall Street firms Sears Financial planners Other companies, organizations and individuals

MCS Use
General Motors (GM), Procter and Gamble (P&G),

and Eli Lilly use simulation to estimate both the average return and the riskiness of new products.

MCS Use: GM
Forecast net income for the corporation Predict structural costs and purchasing costs

Determine its susceptibility to different risks:

Interest rate changes Exchange rate fluctuations

MCS Use: Lilly

Determine the optimal plant capacity that should be

built for each drug

MCS Use: Wall Street

Price complex financial derivatives Determine the Value at Risk (VaR) of investment

portfolios.
By definition, Value at Risk at security level p for a

random variable X is the number VaR_p(X) such that

Pr(X<VaR_p(X))=p

In practice, p is selected to be close to 1: 95%, 99%, 99.5%

MCS Use: Procter & Gamble

Model and optimally hedge foreign exchange risk

MCS Use: Sears

How many units of each product line should be

ordered from suppliers

MCS Use: Financial Planners

Determine optimal investment strategies for their

clients retirement.

MCS Use: Others

Value real options:
Value of an option to expand, contract, or postpone a

project

MCS Applications

Physical Sciences Engineering Computational Biology Applied Statistics Games Design and visuals Finance and business (Actuarial Science) Telecommunications Mathematics

Part II
Well now discuss how Monte Carlo simulation

works by looking at a few simulation examples

=RAND() function
When you enter the formula =RAND() in a cell, you

get a number that is equally likely to assume any value between 0 and 1.
Get a number less than or equal to 0.25 around 25% of

the time
Get a number that is at least 0.9 around 10% of the

time

Example 1: Discrete Random Variable Simulation

Demand for a calendar is governed by the following

discrete r.v.:

DEMAND 10,000 20,000 40,000 60,000

PROBABILITY 0.10 0.35 0.30 .25

Discrete r.v. Simulation(cont.)

How can we have Excel play out, or simulate, this

demand for calendars many times?

We associate each possible value of the RAND

function with a possible demand for calendars.

Discr r.v. Sim (cont.)

The following assignment ensures that a demand of

10,000 will occur 10 percent of the time, and so on.

DEMAND RANDOM NUMBER ASSIGNED

10,000 20,000
40,000 60,000

Less than 0.10 Greater than or equal to 0.10 and less than 0.45
Greater than or equal to 0.45 and less than 0.75 Greater than or equal to 0.75

Discr r.v. Sim (cont.)

Creating the following cutoff table, we then use it to

look up the values assigned to each random number:

TRIAL 1 0.823097422 RAND CUTOFF 0 DEMAND 10,000

SIM DEMAND 60,000

0.1
0.45 0.75

20,000
40,000 60,000

2
0.076074298 3 0.364201634 4 0.698116365

10,000
20,000 40,000

Discr r.v. Sim (cont.)

The function used to create the values in the third

column of the second table is called the VLOOKUP function.

Its syntax in Excel is: VLOOKUP( lookup_value, table_array,

col_index_num, range_lookup )

Discr r.v. Sim (cont.)

Thus, the VLOOKUP(0.823097422, LOOKUP, 2,

1)=60,000
TRUE=1, FALSE=0

If VLOOKUP can't find lookup value, and range

lookup is TRUE, it uses the largest value that is less than or equal to lookup value.

Discr r.v. Sim (cont.)

If we simulate 400 values of calendar demand and

then calculate the fraction of time each demand appears in the simulation, well get a table similar to the following:
DEMAND DEMAND 10,000 FRACTION OF TIME 0.10250 10,000 20,000 40,000 PROBABILI TY 0.10 0.35 0.30

20,000
40,000 60,000

0.35500
0.29250 0.25000

60,000

0.25

Example 2: Normal Random Variable Simulation

Suppose we want to simulate 400 trials or iterations

for a normal r.v. with a mean =40,000 and standard deviation =10,000
What is a normal random variable?
Let us first define the standard normal random

variable.

Standard Normal Random Variable

Its distribution has a form of a bell curve around

the zero.
Standard Normal Distribution Table is a table that

shows probability that a standard normal random variable Z is less than a number z:
(z)=Pr(Z<z)
A standard normal r.v. Z is a r.v. with =0 and =1

Connection between any Normal r.v. and a Standard Normal r.v.

If Z is N(0, 1) and is Y is N(, ^2), then Y=Z+

Normal Random Variable Simulation

Suppose we want to simulate 400 trials or iterations

for a normal r.v. with a mean =40,000 and standard deviation =10,000
The formula NORMINV(RAND(), , ) will generate

a simulated value of a normal r.v. having a mean and standard deviation .

Normal r.v. Sim (cont.)

TRIAL 1 2 3 4 RAND 0.258433031 0.344835199 0.927522163 0.248403053 NORMAL RV 33,518.16 36,006.98 54,575.82 33,204.76

33,518.16 = NORMINV(0.258433031, 40,000, 10,000)

This value could also be looked up using the

Standard Normal Distribution table.

Example 3: How Many Cards to Produce?

Suppose the demand for a Valentines Day card is governed by the following discrete r.v.:
DEMAND 10,000 20,000 40,000 60,000 PROBABILITY 0.10 0.35 0.30 .25

Cards to Produce? (cont.)

The greeting card sells for $4.00 The variable cost of producing each card is $1.50 Leftover cards will be disposed at $0.20 per card

How many cards should be printed to get the highest profit?

Cards to Produce? (cont.)

We simulate each possible production quantity

(10,000, 20,000, 40,000 or 60000) many times (e.g. 1,000 iterations)

Then we determine which order quantity yields the

maximum average profit over the 1,000 iterations

Cards to Produce? (cont.)

1 2 3 4 5 6 7 8 9 10 produced rand demandcard unit prod cost unit price unit disp cost revenue total var cost total disposing cost profit 10,000 0.400927091 20,000 $1.50 $4.00 $0.20 $40,000.00 $15,000.00 $$25,000.00

Cards to Produce? (cont.)

Our sales and cost parameters are in 4, 5, and 6 Enter a trial production quantity in 1 Create a random number in 2 with =RAND() Simulate demand for the card in 3 with

VLOOKUP(rand, lookup, 2)
The number of unites sold is

MIN (Production Quantity, Demand)

Cards to Produce? (cont.)

Revenue in 7: MIN (Produced, Demand)*unit price Total production cost in 8: produced*unit production

cost
If we produce more cards than are demanded, the

number of units left over equals production minus demand

 Disposal cost in 9:

Cards to Produce? (cont.)

unit disposal cost*MAX(produced-demand, 0)

Total profit in 10:

Revenue total var cost total disposing cost

 We would like an efficient way to calculate profit for

Cards to Produce? (cont.)

each production quantity

Well use a two-way data table
mean (ave profit) st dev (risk) 25,000 1 2 3 4 5 24,985 45,984 57,311 44,218

- 12,321.19 48,346.89 73,622.44 10,000 25000 25000 25000 25000 25000 20,000 50000 50000 50000 50000 50000 40,000 16000 100000 16000 100000 100000 60,000 -60000 66000 66000 150000 -18000

Cards to Produce? (cont.) Enter 1-1000 on the left corresponding to our 1,000
trials

Enter possible production quantities (third row)

We want to calculate profit for each trial number and

each production quantity

Refer to the formula for profit in the upper left cell of

our data table by entering =B11

We are now ready to trick Excel into simulating

1,000 iterations of demand for each production quantity.

 Select the table range and then click Table on the

Cards to Produce? (cont.)

Data menu.
Click on any blank cell (e.g. I14) as the column

input cell and choose production quantity (cell B1) as the row input cell.
We calculate the average simulated profit for each

production quantity
We calculate the standard deviation of simulated

profits for each production quantity

Cards to Produce? Conclusion

Producing 40,000 cards always yields the largest

expected profit
However, it also appear to have a large standard

deviation (risk)

The Impact of Risk in Our Decision

Producing 20,000 cards instead of 40,000, the

expected profits drop by about 22%, but the risk drops almost 73%.
Therefore, if we are extremely risk averse,

producing 20,000 cards might be the right decision.

Note that producing 10,000 cards always has a

std.dev. of zero cards because if we produce 10,000 cards we will always sell all of them and have none left over.

Confidence Interval for Mean Profit

Into what interval are we 95% sure the true mean

will fall?
This interval is called the 95% confidence interval

for mean profit.

Its computed by the following formula:

Mean Profit (1.96*profit std.dev.)/(number iterations)

In our example: (53,650.46 59,628.26 )

Problems
1

A GMC dealer believes that demand for 2005 Envoys will normally be distributed with a mean of 200 and standard deviation of 30. His cost of receiving an Envoy is $25,000, and he sells an Envoy for $40,000. Half of all leftover Envoys can be sold for $30,000. His is considering ordering 200, 220, 240, 260, 280, and 300 Envoys. How many should he order?

Problems (cont.)
2

A small supermarket is trying to determine how many copies of Newsweek magazine they should order each week. They believe their demand for Newsweek is governed by the following discrete random variable
DEMAND 15 20 25 30 PROBABILITY 0.10 0.20 0.30 0.25

35

0.15

Problems (cont.)
2

The supermarket pays $1.00 for each copy of Newsweek and sells each copy for $1.95. They can return each unsold copy of Newsweek for $0.50. How many copies of Newsweek should the store order to maximize its profit?

Part III: Advantages of MCS

In conclusion, well discuss some advantages of

MCS over deterministic, or single-point estimate analysis.

Advantages of MCS
MCS provides a number of advantages over deterministic, or single-point estimate analysis:
Probabilistic Results Graphical Results

Sensitivity Analysis
Scenario Analysis

Correlation of Inputs

Probabilistic Results
Results show not only what could happen, but how

likely each outcome is.

Graphical Results
Because of the data a Monte Carlo simulation

generates, its easy to create graphs of different outcomes and their chances of occurrence.
This is important for communicating findings to

other stakeholders.

Sensitivity Analysis
With just a few cases, deterministic analysis makes

it difficult to see which variables impact the outcome the most.

In Monte Carlo simulation, its easy to see which

inputs had the biggest effect on bottom-line results.

Scenario Analysis
In deterministic models, its very difficult to model

different combinations of values for different inputs to see the effects of truly different scenarios.
Using Monte Carlo simulation, analysts can see

exactly which inputs had which values together when certain outcomes occurred.
This is invaluable for pursuing further analysis.

Correlation of Inputs
In Monte Carlo simulation, its possible to model

interdependent relationships between input variables.

Its important for accuracy to represent how, in reality, when some factors go up, others go up or down accordingly.

References
Wayne L. Winston, Microsoft Excel Data Analysis

and Business Modeling, 2004 http://office.microsoft.com/en-us/excelhelp/introduction-to-monte-carlo-simulationHA001111893.aspx

Monte Carlo Simulation

http://www.palisade.com/risk/monte_carlo_simulatio n.asp