applications of monte carlo methods to finance and insurance pdf

Applications Of Monte Carlo Methods To Finance And Insurance Pdf

By Bill Z.
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Risk analysis is part of every decision we make.

Monte Carlo Methods and Models in Finance and Insurance - Ebook

First, the only certainty is that there is no certainty. Second, every decision as a consequence is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly we need to judge decisions not only on the results, but how those decisions were made.

One of the most important and challenging aspects of forecasting is handling the uncertainty inherent in examining the future. Every CEO, CFO, board member, investor, or investment committee member brings their own experience and approach to financial projections and uncertainty—influenced by different incentives.

Oftentimes, comparing actual outcomes against projections provides an appreciation for how large the deviations between forecasts and actual outcomes can be, and therefore the need for understanding and explicitly recognizing uncertainty.

I initially started out using scenario and sensitivity analyses to model uncertainty, and still consider them very useful tools. Since adding Monte Carlo simulations to my toolbox in , I have found them to be an extremely effective tool for refining and improving how you think about risk and probabilities. The approach has always been well received by board members, investors, and senior management teams.

In this article, I provide a step-by-step tutorial on using Monte Carlo simulations in practice by building a DCF valuation model. The concept of expected value —the probability-weighted average of cash flows in all possible scenarios—is Finance But finance professionals, and decision-makers more broadly, take very different approaches when translating this simple insight into practice.

The approach can range from simply not recognizing or discussing uncertainty at all, on one hand, to sophisticated models and software on the other. In some cases, people end up spending more time discussing probabilities than calculating cash flows. Many of these should be familiar to you. Creating one scenario. This approach is the default for budgets, many startups, and even investment decisions. Besides not containing any information about the degree of uncertainty or recognition that outcomes may differ from the projections, it can be ambiguous and be interpreted differently according to the stakeholder.

Some may interpret it as a stretch target, where the actual outcome is more likely to fall short than exceed. Some view it as a baseline performance with more upside than downside. In some approaches, especially for startups, it is very ambitious and failure or shortfall is the more likely outcome by far, but a higher discount rate is used in an attempt to account for the risk. Creating multiple scenarios. This approach recognizes that reality is unlikely to unfold according to a single given plan.

The three different scenarios yield three different results, here assumed to be equally likely. The probabilities of outcomes outside the high and low scenarios are not considered.

Creating base-, upside, and downside cases with probabilities explicitly recognized. A useful benefit of this from a risk management perspective is the explicit analysis of tail risk, i. Illustration from the Morningstar Valuation Handbook. Using probability distributions and Monte Carlo simulations. Using probability distributions allows you to model and visualize the full range of possible outcomes in the forecast. This can be done not only at an aggregate level, but also for detailed individual inputs, assumptions, and drivers.

Monte Carlo methods are then used to calculate the resulting probability distributions at an aggregate level, allowing for analysis of how several uncertain variables contribute to the uncertainty of the overall results.

Perhaps most importantly, the approach forces everyone involved in the analysis and decision to explicitly recognize the uncertainty inherent in forecasting, and to think in probabilities. Just as the other approaches this has its drawbacks, including the risk of false precision and resulting overconfidence that may come with using a more sophisticated model, and the additional work required to select suitable probability distributions and estimate their parameters where otherwise only point estimates would be used.

Monte Carlo simulations model the probability of different outcomes in financial forecasts and estimates. They earn their name from the area of Monte Carlo in Monaco, which is world-famous for its high-end casinos; random outcomes are central to the technique, just as they are to roulette and slot machines.

In the simulation, the uncertain inputs are described using probability distributions , described by parameters such as mean and standard deviation. Example inputs in financial projections could be anything from revenue and margins to something more granular, such as commodity prices, capital expenditures for an expansion, or foreign exchange rates.

When one or more inputs is described as probability distributions, the output also becomes a probability distribution. A computer randomly draws a number from each input distribution and calculates and saves the result. This is repeated hundreds, thousands, or tens of thousands of times, each called an iteration. When taken together, these iterations approximate the probability distribution of the final result.

The input distributions can be either continuous , where the randomly generated value can take any value under the distribution for example a normal distribution , or discrete , where probabilities are attached to two or more distinct scenarios. A simulation can also contain a mix of distributions of different types. This can be combined with continuous distributions describing uncertain investment amounts needed for each stage and potential revenues if the project results in a product that reaches the market.

Excel and Google Sheets hold one number or formula result in each cell, and although they can define probability distributions and generate random numbers, building a financial model with Monte Carlo functionality from scratch is cumbersome. And, while many financial institutions and investment firms use Monte Carlo simulations for valuing derivatives, analyzing portfolios and more, their tools are typically developed in-house, proprietary or prohibitively expensive—rendering them inaccessible to the individual finance professional.

Let us review a simple example that illustrates the key concepts of a Monte Carlo simulation: a five-year cash flow forecast. In this walkthrough, I set up and populate a basic cash flow model for valuation purposes, gradually replace the inputs with probability distributions, and finally run the simulation and analyze the results.

To start, I use a simple model, focused on highlighting the key features of using probability distributions.

Note that, to start off, this model is no different from any other Excel model; the plugins I mentioned above work with your existing models and spreadsheets. The model below is a simple off-the-shelf version populated with assumptions to form one scenario.

First, we need to collect the information necessary for making our assumptions, then we need to choose the correct probability distributions to insert. In my experience, experts and market participants are happy to discuss different scenarios, risks, and ranges of outcomes. However, most do not explicitly describe probability distributions. Let us now walk through and replace our key input values with probability distributions one by one, starting with the estimated sales growth for the first forecast year The RISK plugin for Excel can be evaluated with a day free trial so you can download it from the Palisade website and install it with a few clicks.

You then select one from the palette of distributions that comes up. The RISK software offers more than 70 different distributions to choose from, so choosing one can seem overwhelming at first. Below is a guide to a handful I use most often:. Defined by mean and standard deviation. Johnson Moments. Choosing this allows you to define skewed distributions and distributions with fatter or thinner tails technically adding skewness and kurtosis parameters.

Behind the scenes, this uses an algorithm to choose one of four distributions which reflects the four chosen parameters, but that is invisible to the userall we have to focus on are the parameters. Where probabilities are given to two or more specific values. Distribution Fitting. When you have a large amount of historical data points, the distribution fitting functionality is useful. This does not mean three or four years of historical sales growth, for example, but time series data such as commodities prices, currency exchange rates, or other market prices where history can give useful information about future trends and the degree of uncertainty.

There are different approaches:. To quickly illustrate a distribution as part of discussions or if you need a distribution when drafting a model not easily created from the existing palette, the freehand functionality is useful. As the name implies, this allows you to draw the distribution using a simple painting tool. Now we see a visualization of the distribution, with a few parameters on the left-hand side. The mean and standard deviation symbols should look familiar.

In the case of a normal distribution, the mean would be what we previously entered as a single value in the cell. One benefit of Monte Carlo simulations is that low-probability tail outcomes can trigger thinking and discussions. Only displaying upside and downside scenarios can introduce the risk that decision-makers interpret those as the outer bounds, dismissing any scenarios that lie outside.

With Monte Carlo modeling, be mindful of how uncertainty and probability distributions stack on top of each other, such as over time. For the sake of simplicity, the below example specifies the growth for one year, , and then applies that same growth rate to each of the following years until Another approach is to have five independent distributions, one for each year. We now estimate a probability distribution for the EBIT margin in highlighted below similarly to how we did it for sales growth.

Here, we can use the correlation function to simulate a situation where there is a clear correlation between relative market share and profitability, reflecting economies of scale. Scenarios with higher sales growth relative to the market and correspondingly higher relative market share can be modeled to have a positive correlation with higher EBIT margins.

Depending on the time available, size of transaction, and other factors, it often makes sense to build an operating model and input the most uncertain variables explicitly. These include: product volumes and prices, commodity prices, FX rates, key overhead line items, monthly active users, and average revenue per unit ARPU. Using the outlined approach, we can now continue through the balance sheet and cash flow statement, populating with assumptions and using probability distributions where it makes sense.

A note on capex: this can be modeled either in absolute amounts or as a percentage of sales, potentially in combination with larger stepwise investments; a manufacturing facility may for example have a clear capacity limit and a large expansion investment or a new facility necessary when sales exceed the threshold. Building a Monte Carlo model has one additional step compared to a standard financial model: The cells where we want to evaluate the results need to be specifically designated as output cells.

The software will save the results of each iteration of the simulation for those cells for us to evaluate after the simulation is finished. All cells in the entire model are recalculated with each iteration, but the results of the iterations in other cells, which are not designated as input or output cells, are lost and cannot be analyzed after the simulation finishes.

As you can see in the screenshot below, we designate the MIRR result cell to be an output cell. Outputs Expressed as Probabilities. Whereas our model previously gave us a single value for the modified IRR, we can now clearly see that there are a number of potential outcomes around that value, with different probabilities. The visualization is helpful when communicating the results to different stakeholders, and you can overlay outputs from other transactions to visually compare how attractive and un certain the current one is compared to others see below.

Understanding the degree of uncertainty in the final result. The visualizations provide information about both types of uncertainty. Sensitivity analysis: Introducing the tornado graph. Another important area is to understand which inputs have the greatest impact on your final result.

A classical example is how the importance of discount rate or terminal value assumptions is often given too little weight relative to cash flow forecasting.

Monte Carlo Methods In Financial Engineering

First, the only certainty is that there is no certainty. Second, every decision as a consequence is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly we need to judge decisions not only on the results, but how those decisions were made. One of the most important and challenging aspects of forecasting is handling the uncertainty inherent in examining the future. Every CEO, CFO, board member, investor, or investment committee member brings their own experience and approach to financial projections and uncertainty—influenced by different incentives. Oftentimes, comparing actual outcomes against projections provides an appreciation for how large the deviations between forecasts and actual outcomes can be, and therefore the need for understanding and explicitly recognizing uncertainty.

Skip to content. All Homes Search Contact. Diary-style data analysis for better understanding social networks in Singapore. Through the simulation study, we perceive that the GPD is more suitable in the months of September and November. We observed that individuals were able to retain spatial information of food sources on both a short- and long-term basis and to learn the spatial location of these resources after a single visit. Advisors: Robert Gentleman Kurt Hornik Giovanni Parmigiani In a case study, we manually applied the optimizations common subexpression elimination CSE and dead code elimination DCE to R programs to evaluate their positive impact on the programs' execution times.

Monte Carlo methods are used in corporate finance and mathematical finance to value and analyze complex instruments , portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining the distribution of their value over the range of resultant outcomes. The advantage of Monte Carlo methods over other techniques increases as the dimensions sources of uncertainty of the problem increase. Monte Carlo methods were first introduced to finance in by David B. Hertz through his Harvard Business Review article, [3] discussing their application in Corporate Finance. In , Phelim Boyle pioneered the use of simulation in derivative valuation in his seminal Journal of Financial Economics paper. This article discusses typical financial problems in which Monte Carlo methods are used.

Monte Carlo Methods and Models in Finance and Insurance

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Offering a unique balance between applications and calculations, Monte Carlo Methods and Models in Finance and Insurance incorporates the application background of finance and insurance with the theory and applications of Monte Carlo methods. It presents recent methods and algorithms, including the multilevel Monte Carlo method, the statistical Rom. Sign up to our newsletter and receive discounts and inspiration for your next reading experience. We a good story.

Monte Carlo Methods and Models in Finance and Insurance

introducing monte carlo methods with r pdf

Faster previews. Personalized experience. Get started with a FREE account. Load more similar PDF files. PDF Drive investigated dozens of problems and listed the biggest global issues facing the world today.

Simulating Financial Models: Continuous Paths Introduction Basics of stock price modelling A Black-Scholes type stock price framework An important special case: The Black-Scholes model Completeness of the market model Basic facts of options An introduction to option pricing A short history of option pricing Option pricing via the replication principle Dividends in the Black-Scholes setting Option pricing and the Monte Carlo method in the Black- Scholes setting Path-independent European options Path-dependent European options More exotic options Data preprocessing by moment matching methods Weaknesses of the Black-Scholes model Local volatility models and the CEV model CEV option pricing with Monte Carlo methods An excursion: Calibrating a model Aspects of option pricing in incomplete markets Stochastic volatility and option pricing in the Heston model The Andersen algorithm for the Heston model. Connection between premium principles and risk measures Monte Carlo simulation of risk measures Some applications of Monte Carlo methods in life insurance Mortality: Definitions and classical models Dynamic mortality models Life insurance contracts and premium calculation Pricing longevity products by Monte Carlo simulation Premium reserves and Thiele's differential equation Simulating dependent risks with copulas Definition and basic properties Examples and simulation of copulas Application in actuarial models Nonlife insurance Author: Yiyang Yang Advisor: Pr. Xiaolin Li, Pr. More sophisticated algorithms such as support.

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5 Comments

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    07.05.2021 at 15:29 Reply
  2. Philip L.

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  3. Zdenek T.

    Offering a unique balance between applications and calculations, Monte Carlo Methods and Models in Finance and Insurance incorporates the application background of finance and insurance with the theory and applications of Monte Carlo methods.

    09.05.2021 at 20:20 Reply
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