MonteCarloSimulation in Risk

Financial Education Association
Understanding Portfolio Risk Analysis Using Monte Carlo Simulation

Author(s): Salwa Ammar, Chongyoul Kim and Ronald Wright
Source: Journal of Financial Education, Vol. 34 (FALL 2008), pp. 40-58
Published by: Financial Education Association
Stable URL: http://www.jstor.org/stable/41948840
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Understanding Portfolio Risk Analysis
Using Monte Carlo Simulation
Salwa Ammar, Chongyoul Kim and Ronald Wright

Le Moyne College
Simulation software offers users the opportunity to "experience" hundreds or

thousands of outcomes associated with uncertain events. Dealing with
uncertainty and hence risk is an important component of many finance courses .
This paper describes how the same "experiential" approach used by risk
professionals can be utilized to provide an experiential learning opportunity for
students : This approach helps to bring about an understanding of statistical and
fínancial concepts associated with risk management , beyond what students
might achieve through conventional teaching methods.
INTRODUCTION
Many topics in finance, particularly those related to investment risk, depend highly
on the knowledge of statistical concepts. Unfortunately, even when students have a
rudimentary understanding of statistics, they can find it difficult to translate the
theoretical conception of variances, coefficients of variability, and correlation into
practical appreciation of managing risk. Diversification and portfolio investment and
their benefits are well recognized by finance professionals. However these concepts and
relationships are not easy subjects to many finance students. Mathematical formulas are
available for evaluating the risk of investment portfolios, but even two-asset portfolios
require formulas of enough complexity (Arnold, 2006) that some students will become
more involved in trying to grasp and properly use the formulas than they are in
assimilating the concepts of risk reduction.
In our program's management science courses, faculty members advocate the use of
simulation software to analyze decision-making situations under uncertainty. Simulation
offers analysts the opportunity to "experience" a rich range of outcomes as they evaluate
alternative decisions. Simulation can offer our students that same experiential
opportunity. The utility of spreadsheet based simulation software, such as Crystal Ball
and @Risk, can be easily accessible, particularly to students who are already familiar with
spreadsheets. The manageability of these add-ins makes the use of simulation practical
in a variety of courses. Educators have successfully used simulation to introduce concepts
such as data sampling (Shaffer, 2006; Wright, 2005), variances (Wright 2005), and
40 Journal of Financial Education
Table 1. Summary of Exercises
Exercise
Time series This exercise introduces students to simulation and allows

forecast vs. them to appreciate the difference between simulation results
simulation
Basic investment Once they can perform a simple simulation, this exercise
model using enables students to model a monthly fixed dollar investment in
simulation
Simulating a With both simulation and modeling tools in place, this exercise
portfolio of two allows students to visualize the difference in the risk associated
stocks with a portfolio of two (or more) stocks with that associated
Including Having observed how a portfolio can reduce risk, this exercise
correlation in the allows students to experience the effect that correlation (both
simulation
Experimenting This final exercise allows students to experiment with the risks
with stock associated with their own portfolios of stocks and/or index
portfolios
investment strategies (Foster, 2006). These experiences motivated our use of simulation
software to teach complex finance models.
In our introductory finance courses, students tend to find the concepts of risk versus
return confusing and difficult to grasp, at least initially. All of these students have
already taken introductory statistics and accounting courses and can measure a variety
of factors such as expected returns and variances but without always fully understanding
the context or practical meaning of their calculations. Since the concept of risk is
inherently abstract, students find it helpful to be able to have visual representations of
the hundreds of possible outcomes that result from a computer simulation. A better
appreciation of the abstraction of risk can subsequently enable students to comprehend
both market risk and diversifiable risk more easily
The main purpose of this paper is to demonstrate spreadsheet based simulation
models that facilitate student visualization of risk and return and solidify their under-
standing of these important concepts. In the next section, we will demonstrate how we
first illustrate the difference between simulation and time series forecasting. This will be
followed by a section that introduces the basic simulation model. After presenting the
model, the remaining sections will focus on how the model can be used to introduce the
manner in which portfolios are used to reduce risk, including the importance of taking
into account the correlation between the historical performances of individual
investments within a portfolio. Table 1 contains a list and brief description of the
Fall 2008 41
Figure 1. Projected Stock Prices Using Historical Trend
exercises presented in these sections. Class time requirements for these exercises are
included in a section that follows the detailed description of the exercises. The paper
concludes with a description of some of the model variations we explore throughout the
course as well as a class project in which students create their own investment portfolio
and fully evaluate their performance in the context of both return and risk.
SIMULATION VERSUS TIMES SERIES FORECASTING
The basic model assumes a fixed monthly investment ($100 for example) in a single
stock or a portfolio of stocks for a five year period. We usually suggest a scenario
something like saving for a child's college education, a context in which one may want
a reasonably safe investment strategy. The initial stock price and the simulated monthly
increases are based on historical stock market data. The data is readily available through
a number of internet sites. We use the Yahoo finance site (http://finance.yahoo.com) that
allows students to easily access data for any time period, on a daily, weekly, monthly or
annual basis. The site output includes an adjusted price that takes into account not only
any stock splits but also assumes all dividends have been reinvested into the stock. The
site also provides an easy option for downloading the data into an Excel spreadsheet. We
typically download monthly values for the past ten years.
Once students are familiar with accessing historical data our first exercises illustrates
the difference between the time series forecasting students learned in statistics and
Monte Carlo simulation. For example, consider the historical monthly data for one actual
stock as illustrated in Figure 1. We could certainly use a time series forecasting method
Figure 2. Basic Price Simulation Spreadsheet
to project a trend into the future. The projected values shown are based on a simple trend
line extension. Given time to reflect, few students will believe that the projection is a
likely indicator of future stock prices. At best, it suggests what might happen in the near
future, on average, if the historical trend continues. But the trend forecast deemphasizes
a crucial aspect of the historical data, namely the risk. In contrast, the process of
simulating future stock prices takes into account the historical risk in addition to
historical returns.
A simple simulation model can easily be created within an Excel spreadsheet. The
simulation is based on the change in prices, period to period, rather than on the actual
stock prices. An Excel model can most easily assume two probability distributions for
changes in stock price, normal and lognormal. We will illustrate using a normal
distribution. Figure 2 contains the spreadsheet for this basic model.
Using our downloaded historical monthly prices, we calculate the monthly change
in prices (as a ratio in column C). The sample mean and sample standard deviation for
these ratios define the normal distribution for the simulation. Future monthly changes
in stock price are created in column F using Excel's NORMINV function with the given
Fall 2008 43
Figure 3. Results of Two Simulation Runs for Future Share Prices
probability defined by Excel's RAND function (a uniformly distributed random number

between 0 and 1). Finally, the simulated prices are calculated using the simulated
monthly change to adjust the prices with a single period lag. For the reader's
convenience a time series forecast is included in column H. The equation, y = 0.00004xA3
-.001145xA2 + 0.121305x + 24.432, where x is the time period, is simply the result
produced by one of Excel's trend line options.
Each time a recalculation is performed in the spreadsheet, a new set of simulated
prices is created. A graph of the simulated prices clearly illustrates the difference between
the trend-based forecast in Figure 1 and simulated future prices. By repeated recalcu-
lations students can see the extent to which simulated prices will vary. Figure 3 shows
the results of only two simulations. For classes with students who are familiar with Excel,
this exercise takes very little class time. However it usually provides a huge insight into
the significance of historical risk in addition to historical means. Students enjoy
repeatedly hitting F9 and watching the graph change, illustrating the wide variety of
possible results that can occur. The variation in possible values by the end of the
simulated period further illustrates how much information is lost by focusing only on a
trend-based forecast. Student begin to see that studying this variation and the risk it
represents is just as important or even more important, than focusing on expected
returns.
Figure 4. Basic Investment Model
THE BASIC MODEL
Having demonstrated simulation of stock prices we can begin to evaluate our simple
scenario of investing a fixed dollar amount ($100) per month in a single stock for a period
of sixty months. Figure 4 contains the basic spreadsheet model for just ten months rather
than a full 60 months, merely to simplify the illustration.
The "accumulated shares" in the first month is the number of shares (at the simulated
price) that can be purchased with the available $100. This calculation of course ignores
broker's fees and the high cost of buying a small numbers of shares. In each subsequent
month the shares purchased at that month's simulated prices are added to the previously
accumulated price. In the tenth month the investment is valued by selling the
accumulated shares at the tenth month simulated price.
Each time a recalculation is performed in the spreadsheet new simulated prices occur
and a new investment value appears. If we recalculate 500 times and record the 500
resulting values we will have performed a simulation of this simple investment. The
mean and standard deviation of those 500 simulated values would provide us with an
Fall 2008 45
Figure 5. Simulation Results
estimate of the expected return and the risk of this investment option (assuming the
future followed historical patterns). Excel's Data Table function allows users to record the
results of repeated changes in a spreadsheet. This function can easily be used to record
the results for the repeated recalulations. The data table output is the portfolio value.
The data table inputs are in fact the sequential numbers that represent the desired
number of trials. Typically 500 to 1000 trials are calculated but we merely use 1 through
10 as an illustration. The input cell is actually any empty cell since the purpose of
inputting the values 1 through 10 is only to cause the desired recalculation. Figure 5
contains the data table results for ten trials.
Once we have our trial (or sample results) we can calculate any desired statistics such
as the mean, standard deviation, or coefficient of variability. In addition, frequency
histograms can be created that provide a visual representation of the range of outcomes.
Again the model the students create contains the full 60 investment periods and students
can react to the wide variation of the investment values. It is one thing to observe that
such an investment would have an expected return of some $14,000. It is quite another
to see that the simulated returns vary from $3,000 to over $70,000.
Figure 6. Histogram of Investment Values after 60 Months
With this ability to simulate monthly investments in a single stock, we can introduce
students to the possibility of investing the fixed $100 a month in two or more stocks.
With the simulated outcome of 500 trials, we can calculate expected returns and the risk
associated with the single stock versus a portfolio of stocks. While all of the analysis can
be carried out using basic Excel tools, simulation add-ins such as Crystal Ball or @Risk
make the task much easier. Both tools require very little introduction before students can
begin using them within their spreadsheets. They substantially simplify the simulation
process, add features that are not easily replicated in Excel, and provide enhanced
reporting capabilities. We use Crystal Ball in our classes. Students react very favorable
to its use and even have a sense that they have quickly learned a new tool that they can
look forward to using in both their academic and professional careers. A brief description
of using Crystal Ball for this exercise is provided in an appendix. It illustrates how the
random values for the monthly increase can be set up with a few key strokes while
adding the ability to use numerous distributions. The simulation output is also provided
in a number of formats that allow for easier analysis. For the remainder of this paper we
will utilize outputs generated by Crystal Ball. The most basic outputs are a frequency
histogram of the simulated results (Figure 6) and statistics for the simulated sample
(Figure 7).
Fall 2008 47
Figure 7. Simulation Statistics
The histogram in combination with the calculated data allows student to associate
wide ranges of possible values with larger standard deviation. The statistics provide all
the desired measurements including the coefficient of variability that we use as a basic
measure of risk.
While Crystal Ball has numerous tools that facilitate a wide range of analyses, the
few simple and readily learned steps described in the appendix allow us to perform the
basic analysis we require for this exercise. We can create multiple copies of the
spreadsheet for additional stocks and merely paste in new data, redefine the simulation
assumptions, and run the simulation. Multiple stocks can be repeated on the same
spreadsheet if desired. And most importantly, for our purposes, a portfolio of investments
can be investigated. For example, instead of investing $100 a month in a single stock we
can examine investing $50 a month in each of two stocks and adding the investment
totals to get a portfolio value. In the next section we will look at the results for some
specific stocks and stock portfolios using the model as described up to this point.
MODEL RESULTS FOR SPECIFIC STOCKS AND PORTFOLIOS OF STOCKS
With this ability to simulate an investment we can begin the process of comparing
the results for individual stocks and for portfolios of stocks. As summarized in Figure 7,
the 1000 trials of investing $100 a month in Citicorp for a total of 60 months produced
Table 2. Comparison of Investment Outcomes
Citicorp JP Morgan Chase Portfolio
Mean Return $14,370 $10,419 $12,492
Standard Deviation $7,139 $5,989 $4,621
Coeff. of Variability 0.497 0.575 0.370
investment values that averaged $14,099. However the individual results varied from as
low as $3,144 to a high of $71,159, a substantial range of possible outcomes and hence
evidence of considerable risk. Of course the coefficient of variability provides us with a
relative measure of that risk and hence one that we can use to compare the level of risk
between several investment options. As an initial comparison, consider a similar
investment in JP Morgan Chase. Although Crystal Ball provides us with a variety of
attractive outputs, Table 2 contains only the most basic statistics.
A simple comparison between the two investments allows students to first recognize
that Citicorp has a higher mean value. But by now they are also quick to focus on the
standard deviation, which is also higher for Citcorp. Some students will argue that
because of the higher standard deviation Citicorp is the riskier investment. Most however
will focus on the coefficient of variability and argue that Citicorp might be regarded as
an investment with a higher expected return as well as a lower risk.
But what happens if we invest half our money in each stock? Do we end up
averaging our risk? The simulated results for a portfolio that invests $50 a month in each
stock produces the results shown in the last column of Table 2. As expected, the mean
value is midway between the values for the individual investments, a conclusion that
seems obvious to students. However the standard deviation of the portfolio is lower than
the standard deviation of either stock and the coefficient of variability is substantially
lower than for either individual investment. The portfolio did not average our risk but
rather reduced the risk below that of either investment. Hence the first lesson of risk
management has been reinforced; portfolios are less risky than single investments. Our
students are now eager to purse this concept of using a portfolio to reduce risk.
DEALING WITH CORRELATION
Not every portfolio reduces risk to the same degree. In fact, in our example, Citicorp
and JP Morgan Chase are both financial stocks. As the economy causes one stock price
Fall 2008 49
Table 3. Summary of Results with and without Correlation Assumptions
Citicorp JP Morgan Chase Portfolio

Uncorrected Results
Mean Return $14,370 $10,419 $12,492
Positively Correlated (0.72)
Mean Return $14,414 $10,578 $12,496
to increase the other is likely to increase as well. That is, the monthly increases in the two
stocks are likely to be correlated. If the correlation between stocks is ignored, the selection
of the randomly simulated values for one stock will be completely independent of the
values for another. Hence we could easily have many months in which the simulated
values for Citicorp showed substantial increases while the simulated values for JP Morgan
declined. When considering individual stocks, the timing of the ups and downs is less
important as we consider the average results over the 1000 trials. However when
considering a portfolio that combines monthly investments in the two stocks, having
many months in which Citicorp goes up while JP Morgan goes down (and vice versa) will
distort the results. When using Crystal Ball to define our probability distributions we have
the option to correlate the simulated values. The historical monthly increases for Citicorp
and JPM are in fact correlated with a value of 0.72 (rank correlation). When the
correlation option is selected, the randomly selected values for JPM will be selected in
such way that the results maintain a 0.72 correlation with the random values for Citicorp.
When we rerun our simulation using correlated values we find that a portfolio
of two banking stocks does not substantially reduce our risk. Specifically the coefficient
of variability for the positively correlated portfolio increases from 0.370 (for the
uncorrected simulation) to 0.472, nearly the same as the value for Citicorp alone.
Students can readily conclude that combining two stocks that are likely to react similarly
to various market conditions in fact does not reduce the overall investment risk. A
comparison of the difference results when correlation is taken into account is included in
Table 3.
Table 4. Summary of Extreme Correlation Examples
Stock A Stock B Portfolio
Uncorrected Results
Mean Return $14,370 $14,067 $14,219
Fully Positively Correlated (+1.00)
Mean Return $14,370 $14,370 $14,370
Fully Negatively Correlated (-1.00)
Mean Return $14,370 $14,011 $14,191
Coeff. of Variability 0.497 .550 0.174
By now students can appreciate that a portfolio of even two stocks reduces risk over
an investment in a single stock. In addition they start to appreciate that the selection of
the stocks can have a substantial impact. Clearly, if the intent is to reduce risk, a selection
of stocks that are not correlated produces better results (on average) than is obtained with
highly correlated stocks. This naturally raises the question of the potential value of seeking
stocks that are negatively correlated. In many instances, demonstrating extreme
alternatives helps students to better understand some basic concepts. Our simulation
model can of course also be used to investigate theoretical possibilities as well as real
stocks. Our next exercise considers the extreme case of having two stocks with identical
historical means and standard deviations but that are first uncorrected, than fully
positively correlated, and finally fully negatively correlated. We will use the historical
data for Citicorp to define the distributions for both of our hypothetical stocks, Stock A
and Stock B. In each case we will consider the results for the individual stocks, and a
portfolio made up of 50% investment in each stock. The results are summarized in Table
4.
Fall 2008 51
Figure 8. Positively Correlated Results
When no correlation is assumed, the two stocks with identical average historical data
will behave similarly on average. However since no assumption was made that one stock
must increase as the other one does, the random ups and downs of the two different stocks
still reduces risk in the portfolio. If we assume full correlation between the two stocks,
then one must vary identically to the other and combining two identically performing
stocks results in no reduction in risk. If we assume the stocks are fully negatively
correlated more interesting results occur. Again we have simulated two different stocks
that have the same historical returns and risks. However in this case our model assures
that whenever one stock goes up the other will go down. Our average return is not
impacted at all. However the risk has been substantially reduced.
When performing this exercise in class, the results are recorded for each scenario
individually with students having the opportunity to discuss prior to each run what they
believe will happen and then to compare their predictions with the simulated results. Note
that all three scenarios have the identical results for Stock A because we selected the
option to use the same random number seed for each simulation thus eliminating any
difference resulting solely as a consequence of the difference in the 1000 random values.
Figures 8 and 9 illustrate the demonstrative value of the graphical interpretation for
Figure 9. Negatively Correlated Results
the results. Students can easily visualize the lower variation and hence lower risk
associated with the negatively correlated scenario. It is particularly instructive for students
to be able to observe the visual difference between two investment options that have the
same expected return but very different levels of risk. Students can also use one of the
Crystal Ball options to determine the percent of the 1000 trials that resulted in a final
investment value in excess of $10,000. When no correlation is assumed, 68.2 % of the
trials resulted in a final investment value of $10,000 or more. When a full negative
correlation is assumed, 100% of the trials resulted in $10,000 or more.
At this point our students are fully convinced that portfolios will reduce risk as long
as they contain diverse investments. They realize that ideally risk can be reduced even
further by balancing portfolios with stocks that will perform differently in various
economic conditions. For the finance professor this creates the perfect opportunity to
discuss the economic relationships between various industries. For example is there
evidence that when oil stocks go up that transportation stocks tend to decline?
Fall 2008 53
UNDERSTANDING THE STOCK MARKET
Using examples from the stock market helps to convince students that the theories of
risk management have real applicability. It also helps students develop a much better
understanding of the market and its history. As a project, we ask students to use Crystal
Ball to guide them in selecting a portfolio of stocks that is likely to perform well over a five
year period. The context is the same as in our example. A given amount is to be invested
monthly in the selected portfolio of stocks with an objective of obtaining reasonable
growth in the assets but without excessive risk. Students can select any stocks they wish.
Those with minimum experience often select from stocks in the Dow Jones Industrial
Average index. Students are also encouraged to limit their stocks to a total of four. In
addition they have the option of investing in a mutual fund that buys only stocks in the
DJIA index. The value of this fund is tracked by using the adjusted value of the DJIA. The
project should compare portfolio investments versus risk free investments such as treasury
bills.
Students are expected to also evaluate their portfolios by comparing the predicted
results based on ten years of historical data to those from simulations using only the most
recent five years. This helps emphasize that the past is not a perfect predictor of the
future. Students will observe that the past five years have been very different from the five
years before that. However, the instructor will have the opportunity to point out that, in
some measures, the two time periods are very similar. The mean increase for each of the
stocks in the DJIA is for the most part higher in the first five year period versus the most
recent five years. Nonetheless, the standard deviation of the increase for each stock
changes little over those two periods. In general, the past is not a great predictor of the
mean increase in stock value. However, it can be considered a reasonable predictor of the
standard deviation of the change in stock values and consequently of the risk.
The experience of downloading stock market data and comparing the historical results
leads students to a better appreciation of the workings of the markets, the interactions
between market sectors, and the potential gain and risk associated with investing in the
markets.
TIMING AND LOCATION OF THE EXERCISES
The amount of class time devoted to these exercises depends on the emphasis the
instructor wants to give to these topics, the abilities of the students, and the extent to
which students might be using simulation for subsequent topics. Table 5 contains a
summary of how these exercises are typically placed within a classroom. The minimum
time requirement is realistically two and one half hours of class time. If one of the goals
is to enable students to use simulation models in future contexts, more class time would
be spent emphasizing and understanding the simulation process and the use of Crystal
Ball. Similarly instructors who wish to discuss the relationships between different market
sectors will spend more time discussing and illustrating the impact of correlation. In
Table 5. Summary of typical class time use
Exercise
Time series forecast These two exercises are done in class. If the course is done
vs simulation in a lab students actually follow along creating their own

spreadsheets. The entire exercise is completed within one
Basic investment instructor the exercise can be completed within a 50

model using minute class. In this case it is helpful if the students have
simulation the opportunity to create the appropriate spreadsheets as an
Simulating a These two exercises are also completed in class and can be
portfolio of two squeezed into in one 75 minute class. However we
stocks commonly use at least part of a second class period. One
class is devoted to learning to use Crystal Ball (along with
some of its features) and to setting up the model to easily
- - : -
Including r .
... . focuses r on the reduction in risk and the impact of
correlation ... in the . . T__ _ _ , .
, . correlation. . T__ Ir Crystal y Ball is not used, correlation , . cannot be
simulation . ... y _ . ^ , i - .
easily ... incorporated into . an Excel ^ spreadsheet. , i In this . case it
is likely that everything is completed within the one 75
minute class period
Experimenting with This final exercise is an out of class assignment for students,
stock portfolios They are typically given at least two weeks to experiment
with a range of investment options and to write a report
general students react very positively to these exercises and extra time used building on
that interest is typically well spent.
FINAL OBSERVATIONS
Risk management and stock market investment strategies are not limited to reducing
risk through diversification. Other investment strategies can be modeled as well. In the
basic model we assumed monthly purchases of stock regardless of the price. Can better
strategies be developed that seek to time purchases to rising or failing prices? Should
portfolios be rebalanced based on the performance of particular stocks? Should some
portion of the portfolio always be in cash, and if so what is the purpose of the cash? What
about purchasing stock options? A spreadsheet simulation model can be developed to
represent any investment situation for which uncertainty can be depicted by probability
Fall 2008 55
distributions (Evans, 2002). The simulation results prevent focusing on expected values
and encourage an evaluation based on the variation in the investments. In addition, the
stock market simulation exercise provides a variety of experiential elements that entice
students and promote their curiosity.
As a final comment, many of the tools of management science are no longer restricted
to expert users. We have successfully encouraged novice modelers to utilize many
Operation Research and Management Science tools. Spreadsheet models are created every
day by non OR/MS experts in thousands of businesses and non-profit organizations
(Willemain, 2006). It is just as appropriate that we encourage our academic colleagues to
use some of these methods as effective teaching tools. Simulation models offer a wealth
of opportunities for experiential learning, particularly in finance courses. It is not difficult
to start to imagine as well how simulation could be used in marketing courses. Uncertainty
abounds and the value of experience (even simulated experience) is evident in every area
of business, industry, and society as a whole.
REFERENCES
Arnold, T., Nail, L.A., & Nixon, T.D., "Getting More Out of Two-Asset Portfolios", Journal
of Applied Finance, 2006, Vol.16, No.l.
Evans, J.R., and Olson, D.L., Introduction to Simulation and Risk Analysis, Upper Saddle
River, New Jersey: Prentice Hall, 2002.
Foster, D.P., and Stine, R.A., "Being Warren Buffett: A Classroom Simulation of Risk and
Wealth When Investing in the Stock Market", The American Statistician , 2006, Vol.
60, No.l, pp. 53-60.
Shaffer, S.M., "Using Spreadsheets and Crystal Ball to Assist in Understanding and
Modeling Distributions of Random Variables", Decision Sciences Journal of
Innovative Education, 2006, Vol. 4, No. 1, pp. 153-162.
Willemain, T.R., and Powell, S.G., "Teaching Novices to Model", ORMS Today ; 2006,
Vol.33, No.l, p 12.
Wright, R. and Lepak, G., Introduction to Business through Statistics , 2005, Syracuse, New
York: Ammar Wright.
APPENDIX: USING CRYSTAL BALL
Simulation add-ins, such as Crystal Ball, allow users to apply simulations to Excel
spreadsheets. Crystal Ball can be used to determine the appropriate probability
distribution for the historical data, produce simulated values, and record and analyze the
result of any number of simulation trials.
Figure Al. Spreadsheet for Crystal Ball Model
In our basic Excel model we could easily run simulations assuming normal and
lognormal distributions. Other distributions are possible but become excessively
cumbersome given our instructional purpose. Comparing distributions may require
goodness-of-fit tests. Crystal Ball gives us a full range of possible distributions and
automates the entire process of comparison. For example consider the Excel spreadsheet
in Figure Al. It is similar to the model we created in Figure 4 of the paper. It covers 60
future months and contains the historical monthly changes for a ten year period for a
particular stock (Citicorp). In the cells representing the simulated monthly change
(E6:E65) we have entered a single value merely as a place holder. The mean of the
historical values is often used but the value will be repeatedly replaced by randomly
generated values in the course of the simulation. The other cells are calculated as shown
previously in Figure 4.
In order to generate the simulated values for the 60 monthly changes, we utilize the
Define option in Crystal Ball. Since Figure Al represents a spreadsheet with the Crystal
Ball add-in, the menu bar includes three new items: Define, Run, and Analyze. In order
to define the random distribution for a particular cell, starting with E6 for example, the
user selects the Define menu. The menu includes a Define Assumptions option that allows
the user to define a particular distribution for the random values or to have Crystal Ball
fit a distribution to historical data. After entering the cells containing the historical values
Fall 2008 57
Figure A2. Goodness-of-Fit Output
B6:B125) the user is shown a screen, Figure A2, that contains the results of goodness-of-fit
tests for thirteen distributions using three different tests: chi-square, Kolmogorov-
Smirnov, or Anderson-Darling. The user merely selects the desired distribution and the
simulation assumption is defined for the designated cell. A copy function (in the Define
menu) allows the defined assumptions to be applied to the remaining 59 cells (E7:E65).
Hence what was accomplished in Excel using the NORMINV and RAND functions is
processed by a few key strokes.
The next task is to indicate the output value or values that Crystal Ball should record
during the repeated trials. This is easily accomplished by highlighting the desired cell,
(Gl in our example) the investment value after 60 months, and again accessing the Define
menu. In this case selecting the Define Forecast option allows the user to assign a name
to the forecast value and identifies the cell as the one to be tracked during the simulation.
This step corresponds to defining the output of the data table in our spreadsheet (without
Crystal Ball) version. Everything is now set up for a simulation.
A simulation run is accomplished simply going to the Run menu and selecting Start
Simulation. Crystal Ball will place randomly generated values for the 60 monthly increases
from the appropriate distribution and keep track of the "investment value after 60
months" for each of the simulated runs. Typically 1000 trials are used. The result of the
simulation can be either a histogram or a table of statistical measures.

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MonteCarloSimulation in Risk

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Financial Education Association

Understanding Portfolio Risk Analysis Using Monte Carlo Simulation

Salwa Ammar, Chongyoul Kim and Ronald Wright

Simulation software offers users the opportunity to "experience" hundreds or

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Time series This exercise introduces students to simulation and allows

SIMULATION VERSUS TIMES SERIES FORECASTING

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probability defined by Excel's RAND function (a uniformly distributed random number

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THE BASIC MODEL

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MODEL RESULTS FOR SPECIFIC STOCKS AND PORTFOLIOS OF STOCKS

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Citicorp JP Morgan Chase Portfolio

Mean Return $14,370 $10,419 $12,492

Standard Deviation $7,139 $5,989 $4,621

Coeff. of Variability 0.497 0.575 0.370

DEALING WITH CORRELATION

Citicorp JP Morgan Chase Portfolio

Mean Return $14,370 $10,419 $12,492

Standard Deviation $7,139 $5,969 $4,624

Coeff. of Variability 0.497 0.545 0.370

Positively Correlated (0.72)

Mean Return $14,414 $10,578 $12,496

Standard Deviation $7,087 $5,686 $5,896

Coeff. of Variability 0.492 0.538 0.472

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Stock A Stock B Portfolio

Mean Return $14,370 $14,067 $14,219

Standard Deviation $7,139 $7,506 $5,165

Coeff. of Variability 0.497 0.534 0.363

Fully Positively Correlated (+1.00)

Mean Return $14,370 $14,370 $14,370

Standard Deviation $7,139 $7,139 $7,139

Coeff. of Variability 0.497 0.497 0.497

Fully Negatively Correlated (-1.00)

Mean Return $14,370 $14,011 $14,191

Standard Deviation $7,139 $5,741 $2,466

Coeff. of Variability 0.497 .550 0.174

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TIMING AND LOCATION OF THE EXERCISES

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vs simulation in a lab students actually follow along creating their own

Basic investment instructor the exercise can be completed within a 50

APPENDIX: USING CRYSTAL BALL

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