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Importance of Monte Carlo Simulation, Essay Example

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Monte Carlo simulation is a technique used by analysts in cost, project management and financial forecasting models in order to understand the impact of risk and uncertainty. Computations of result in the Monte Carlo experiments are based on repeated random sampling of computational algorithms. Because of the use of repeated random sampling of numbers are normally used, computation of deterministic algorithms is impossible. Although used in various fields such as calculation of business risk; evaluation of definite integrals in mathematics; and risk analysis instead of human intuition, the techniques have wider use in finance.

In finance, Monte Carlo techniques, help in the analysis of portfolios, instruments and investments. The analysis takes the form of modeling of the numerous possible causes of uncertainty by computing the averages depending on the results. Unlike other simulation methods, Monte Carlo allows for increased dimensions and factors of uncertainty in a given situation. Financial analysts in project finance, corporate finance and real options analysis use Monte Carlo methods to model probabilistic and stochastic financial models. Similarly, options on equity are valued using simulations generated through random price paths.

Bonds and bond options valuation also employs Monte Carlo techniques to identify the short rate; which derives the element of uncertainty from annual interest rate for which borrowers can borrow money over a specified period. The analysis gives an interest rate different from a yield curve and bond price. The value of the bond is therefore determined by averaging the bond prices, while the bond option value is derived from averaging the exercise values and present value computed.

Personal financing planning also employs Monte Carlo techniques such as determining the possibility of a 401(k) allowing for retirement on earnings can be deduced by simulating the entire market. The simulation allows the entity to either start saving more or decide to take up more risks with the retirement package.

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