LOS P and Q require us to:
p. explain Monte Carlo simulation and describe its applications and limitations;
q. compare Monte Carlo simulation and historical simulation.
a. In the traditional scenario analysis, the analysts assign a probability to all the variables under different scenarios. Based on these probabilities, the values are assigned to future expectations.
b. In the Monte-Carlo simulation, various distributions are given as inputs for different variables, to analyze the expected future results under different conditions. In the Monte-Carlo simulation, we create a model that generates random observations for each variable distribution, without any cause-effect relationship.
c. Monte-Carlo Simulation involves the following steps:
i. Specify the quantities of the variables of interest, such as the mean and variance of the stock prices.
ii. Specify the time periods and sub-periods for each of the variables.
iii. Specify the distributional assumptions for each of the behavior. It should be noted that the results of the simulation are only as good as the assumptions.
d. The problem with using the Monte-Carlo Simulation is that:
i. It is historical in nature and assumes that the past is representative of future behavior.
ii. If, however, the variable did not occur in the past there is no history of it.