Risk Management

Monte Carlo Simulation

Problem 1: Shankar is a newsboy. One of the daily newspapers that Shankar sells from his newsstand is the Financial
Journal. A distributor brings the day’s copy of the Financial Journal to the newsstand every morning. Any copies unsold at
the end of the day are returned to the distributor next morning. However, to encourage ordering a large number of
copies, the distributor does give a small refund for unsold copies. Here are Shankar’s cost figures:
Shankar pays Rs. 1.50 per copy delivered
Shankar sells it at Rs. 2.50 per copy
Shankar’s refund is Rs. 0.50 per unsold copy.
Partially because of the refund, Shankar always has taken plentiful supply. However, he has become concerned about
paying so much for copies that then have to be returned unsold, particularly since this has been occurring every day. He
now thinks he might be better off by ordering only a minimal number of copies and saving this extra cost. To investigate
this further, he has compiled the following record of his daily sales. Shankar sells anywhere between 40 and 70 copies
inclusively on any given day. The frequency of numbers between 40 and 70 are roughly equal. The decision that Shankar
needs to make is the number of copies to order per day. His objective is to maximize his average daily profit.
What happens to the optimal ordering decision if the demand follows a normal distribution with mean 50 and standard
deviation 15?
What happens to the optimal ordering decision if the demand follows the following discrete distribution?

Demand Probability
40 0.3
45 0.2
50 0.3
55 0.15
60 0.05

Problem 2: PortaCom manufactures printers. PortaCom’s product design group developed a prototype for a new high-
quality printer. Preliminary marketing and financial analysis provided the following estimates:
Administrative costs=Rs.400000
Advertising cost=Rs.600000.
Labor cost=Rs.450/unit
Cost of parts=Rs.1000/unit
Demand is not known for certain and is considered probabilistic inputs. Demand is forecasted to follow normal
probability distribution with mean 500 units and standard deviation of 50 units.
Selling Price=Rs.3500/unit
PortaCom would like an analysis of the profit potential for the printer. Because of tight cash flow situation management
is particularly concerned about the potential for a loss.

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Problem 3: Brown Telecommunication Services needs to determine how many telephone operators to employ. The
management at Brown estimates that the number of phone calls received each hour of a typical 8-hour shift can be
described by the following probability distribution:
Calls Probability
80 0.10
120 0.40
160 0.30
200 0.15
300 0.05

Each operator can handle 15 calls per hour and costs the company $20 per hour. Each phone call that is not handled is
assumed to cost the company $6 in lost profit. Use Simulation in Excel to determine the number of operators that
minimizes the expected hourly cost (labor plus lost profits). Run your simulation model for 1000 iterations and then
make your decision.

Problem 4: You just bought an expensive car and now need to buy auto insurance. You are considering two insurance
policies, the first one has a deductible of Rs.10000 and yearly premium of Rs.820 and the second one has a deductible of
Rs.5000 and a yearly premium of Rs.1500. Each year there is a probability of 0.3 of having an accident. The damage
amount if an accident occurs follows the discrete probability distribution given below:

Damage Amount (Rs.) Probability

2000 0.3
4000 0.2
8000 0.1
12000 0.2
20000 0.2

Which insurance policy should you pick?

Problem 5: You are managing the warehouse of a major retailer. Everyday truckloads of materials arrive at the
warehouse. The number of trucks arriving and the probability are given in Table 1. The daily unloading rate is also
stochastic based on the nature of the products being unloaded. The probability distribution of the daily unloading rate is
given in Table 2. Trucks are unloaded based on a first-in, first-out basis. Any truck not unloaded the day of arrival must
wait until the following day. Run a 1000-day simulation model to deduce: (i) the average number of trucks delayed, (ii)
the average number of trucks unloaded each day.

Table 1:
Number of Trucks Probability
Arriving
0 0.13
1 0.17
2 0.15
3 0.25
4 0.20
5 0.10
Table 2:
Daily Unloading Rate Probability
1 0.05
2 0.15
3 0.50
4 0.20
5 0.10

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Problem 6: General Auto Corporation (GAC) is developing a new model of compact car. The car is assumed to
generate sales for the next 5 years. GAC has gathered information about the following quantities through focus groups
with marketing and engineering departments:

• The fixed cost of manufacturing the cars is $1.9 billion. The fixed cost is incurred at the beginning of year 1, before
any sales are recorded.
• Margin per car: This is the unit selling price minus the variable cost of producing a car. GAC assumes that in year 1
the margin will be $5000. Every other year the margin will decrease by 4%.
• The demand for the car is uncertain. GAC assumes that the demand for the cars is normally distributed with mean
140,000 and standard deviation 30,000. Every year after that sales decreases by 5% of the sales made in the previous year.
• The discount rate is 15%.
Using a simulation model help GAC evaluate the NPV of the cash flows for this new car over the 5-year horizon.

Problem 7: Stock prices are estimated using Geometric Brownian Motion based on the following equation:

St  d2
ln( ) = (  d − )t +  d N (0,1) t
St −1 2

You are deliberating to buy 1000 stocks of Indian Oil Corporation Ltd (IOCL). You have collected IOCL’s stock price
for the last 252 trading days (StockPriceData.xlsx). Use the historical stock prices and the above equation to simulate
stock prices of Indian Oil Corporation Ltd for the next 30 days and calculate the average value of the investment and its
standard deviation based on the simulated stock prices on day 30.

Problem 8: Develop a simulation model for a 3-year financial analysis of total profit based on the following data and
information: Sales volume in the first year is estimated to be 100,000 units and is projected to grow at a rate that is
normally distributed with a mean of 7% per year and a standard deviation of 4% per year. The selling price is $10 in year
one and the price increase is normally distributed with a mean of $0.50 and standard deviation of $0.05 each year. Per
unit variable costs are $3 in year one and is expected to increase by an amount normally distributed with a mean of 5%
per year and standard deviation of 2% per year. Fixed costs of $200,000 are incurred annually (for the three years). Based
on 1000 simulations, find the average and the standard deviation of the 3-year cumulative profit. What is the VaR at 90%
confidence level for the 3-year cumulative profit?