Introduction to Financial Risk Analysis Using Monte Carlo Simulation.
What is Monte Carlo Simulation?
Monte Carlo simulation, or probability simulation, is a technique used to understand the impact of risk and uncertainty in financial, project management, cost, and other forecasting models.
What Monte Carlo Simulation can Tell You:
When you have a range of values as a result, you are beginning to understand the risk and uncertainty in the model. The key feature of a Monte Carlo simulation is that it can tell you – based on how you create the ranges of estimates – how likely the resulting outcomes are.
How It Works:
In a Monte Carlo simulation, a random value is selected for each of the tasks, based on the range of estimates. The model is calculated based on this random value. The result of the model is recorded, and the process is repeated.
A typical Monte Carlo simulation calculates the model hundreds or thousands of times, each time using different randomly-selected values.
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When the simulation is complete, we have a large number of results from the model, each based on random input values. These results are used to describe the likelihood, or probability, of reaching various results in the model.
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