Quantifying Financial Risk with Monte Carlo Simulations

Abstract

Many organizations use financial models to forecast, organize, analyze and report the likely impacts of the future’s unknowns on financial outcomes. Financial models cannot replace the manager, but an effective model can complement and improve professional judgment. Many educational programs feature some financial modeling (e.g., with spreadsheet software such as Excel®). However, many of these educational applications fail to fully use the ability of spreadsheet models to address risk beyond limited forecasting impacts of a few, possible variable realizations via sensitivity or scenario analyses. On the other hand, extending financial models to Monte Carlo simulations can quantify risk as the expected odds of an adverse outcome, such as failing to meet a contractually required financial ratio. The purpose of this applied research note is to describe how to develop financial models that use Monte Carlo simulations to quantify financial risk. This note concludes with a classroom-tested case example.

Keywords: financial risk, simulated business model, forecasting

JEL Classification: G30