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What Is Monte Carlo Simulation? How Does It Work?

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Monte Carlo can be stated as a computerized mathematical method which helps or rather allow people to identify the different risks that is related to the decisions and different type of analysis. This method is used by the professionals in different sectors such as project management, engineering, finance, research, transportation and in number of different sectors. The Monte Carlo simulation helps the decision maker by helping them with the different possibilities of risk that can occur related to the choice of action. This method was first introduced by the scientists who were working on the atom bomb. It was first introduced during the World War II and due to this reason it is used in variety of conceptual and physical systems. It helps in detecting and elaborating the possible impact that can occur due to certain decisions. The name Monte Carlo comes from the famous casinos which is situated in the town of Monaco.

The Monte Carlo Simulation is used as it performs different types of analysis and evaluations. The simulation process performs different type of risk analysis. The risk analysis is done by building different models which are based on the possible results where the values are substituted depending upon the uncertainty. The entire calculation is based upon the different number of uncertainty that can occur. The result can be involving recalculations which can be thousand times or even greater than it, before the completion of the entire calculations. The result is the values of the possible outcomes. The distributions which is related with the probability are realistic and describes the various ways and uncertainty involved with the variables in the process of risk analysis. There are different types of probability distributions such as normal, uniform, discrete, triangular, PERT and lognormal. There are various advantages related with the Monte Carlo simulation as the result not only shows what can happen it also shows the outcomes related with the analysis. It helps in the creation of different types of graphs which is helpful for the stakeholders. However, it is one of the useful method which helps in risk analysis.

For example, the Monte Carlo process is useful for analysis of risk related with a particular portfolio. It helps in predicting the worst scenarios which is expected from the portfolio. There are two different constants which helps in representing the market value. The drift, variance, average and standard deviation is determined. In order to find the price trajectory, the historical price data is used. the data is generated as a series of the daily returns which is measured periodically. The method uses the logarithmic value. The average daily return is determined. The frequencies which is generated by different simulation helps in the formation of the normal distribution. This type of curve is known as the bell curve. Most likely the return is observed in the middle of the curve where there is high chance of equal and actual return. However, the Monte Carlo simulation eliminates and ignores everything which is not related with the price movement. It is one of the method which is used in risk analysis.

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