Principles of Financial Modelling

CHAPTER 16The Modelling of Risk and Uncertainty, and Using Simulation

INTRODUCTION

This chapter extends the discussion of simulation that was begun in Chapter 15. We describe the origins, uses and main benefits of simulation techniques (with a focus on risk and uncertainty modelling), and describe some key ways to implement these. We cover the basic use of VBA macros, as well as highlighting some key benefits of using Excel add-ins, such as @RISK. A few simple examples of core applications (risk registers and cost budgeting) are shown, using both Excel/VBA and @RISK. The author's Business Risk and Simulation Modelling in Practice Using Excel, VBA and @RISK provides a much more extensive discussion of risk assessment processes and the issues involved in the design and implementation of risk models; the interested reader is referred to that text.

THE MEANING, ORIGINS AND USES OF MONTE CARLO SIMULATION

Definition and Origin

Monte Carlo Simulation (“MCS”, or simply “simulation”) is the use of random sampling to automate the process to recalculate a model many times as several inputs are varied simultaneously. The creation of randomness per se is not an objective of simulation; rather its role is to allow for automation of the process, and to ensure that a wide set of input combinations is used.

The first large-scale use of simulation was in the 1940s by scientists working on nuclear weapons projects at the Los Alamos National Laboratory in the USA, where it was used to compute ...