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

PROBABILITY

10,000

0.10

20,000

0.35

40,000

0.30

60,000

.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

Less than 0.10

20,000

Greater than or equal to 0.10 and less

than 0.45

40,000

Greater than or equal to 0.45 and less

than 0.75

60,000

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 RAND

CUTOFF DEMAND
0

10,000

0.1

20,000

0.45

40,000

0.75

60,000

1
2
3
4

SIM
DEMAND

0.82309742 60,000
2
0.07607429 10,000
8
0.36420163 20,000
4
0.69811636 40,000
5

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

FRACTION
OF TIME

DEMAND

PROBABIL
ITY

10,000

0.10

10,000

0.10250

20,000

0.35500

20,000

0.35

40,000

0.29250

40,000

0.30

60,000

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

RAND

NORMAL RV

0.258433031

33,518.16

0.344835199

36,006.98

0.927522163

54,575.82

0.248403053

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

PROBABILIT
Y

10,000

0.10

20,000

0.35

40,000

0.30

60,000

.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

produced

2
3
4
5
6
7
8

rand
demandcard
unit prod cost
unit price
unit disp cost
revenue
total var cost

9
10

10,000
0.40092709
1
20,000
$1.50
$4.00
$0.20
$40,000.00
$15,000.00

total disposing cost

$profit
$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

Cards to Produce?
(cont.)

Disposal cost in 9:

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

Total profit in 10:

Revenue total var cost total disposing cost

Cards to Produce?
(cont.)

We would like an efficient way to calculate

profit for 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
20,000
40,000
60,000
25000
50000
16000
-60000
25000
50000
100000
66000
25000
50000
16000
66000
25000
50000
100000
150000
25000
50000
100000
-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.

Cards to Produce?
(cont.)

Select the table range and then click Table on

the 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

PROBABILITY

15

0.10

20

0.20

25

0.30

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_si
mulation.asp