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Rob's e2700 Notes

🔎 Monte Carlo

Monte Carlo analysis is complex, and it is difficult to do justice to it unless the course requires both programming and sophisticated understanding of probability.

Modeling Process

  • Step 1: Model Project
    • Decide how the critical variables affect the outcome
    • Make a spreadsheet which relates the critical variables to the NPV.
  • Step 2: Specify Probabilities
    • Decide on the probabilities of critical variables having various configurations of outcomes (there is covariance and correlation in the background).
  • Step 3: Calculate Free Cash Flows (FCF) for every possible combination of the critical values
  • Step 4: Calculate Present Value
  • (Step 5: Make a pretty graph to indicate which outcomes are most likely) Simulate the entire process 10,000 times and make a histogram of the NPV that includes each “run” of the model.
cash flow simulation

Here is a 2021 article about Monte Carlo for Risk Managers:
https://www.garp.org/risk-intelligence/credit/the-case-for-monte-carlo-simulations