Risk Analytics

Monte Carlo Simulation

Problem 1: Shankar is a newsboy. One of the daily newspapers that Shankar sells from his newsstand is the
Financial Journal. A distributor brings the days copy of the Financial Journal to the newsstand every morning.
Any copies unsold at the end of the day are returned to the distributor next morning. However, to encourage
ordering a large number of copies, the distributor does give a small refund for unsold copies. Here are
Shankars cost figures:
Shankar pays Rs. 1.50 per copy delivered
Shankar sells it at Rs. 2.50 per copy
Shankars refund is Rs. 0.50 per unsold copy.
Partially because of the refund, Shankar always has taken plentiful supply. However, he has become concerned
about paying so much for copies that then have to be returned unsold, particularly since this has been
occurring every day. He now thinks he might be better off by ordering only a minimal number of copies and
saving this extra cost. To investigate this further, he has compiled the following record of his daily sales.
Shankar sells anywhere between 40 and 70 copies inclusively on any given day. The frequency of numbers
between 40 and 70 are roughly equal. The decision that Shankar needs to make is the number of copies to
order per day. His objective is to maximize his average daily profit.
What happens to the optimal ordering decision if the demand follows a normal distribution with mean 50 and
standard deviation 15?
What happens to the optimal ordering decision if the demand follows the following discrete distribution?
Demand Probability
40 0.3
45 0.2
50 0.3
55 0.15
60 0.05

Problem 2: PortaCom manufactures printers. PortaComs product design group developed a prototype for a
new high-quality printer. Preliminary marketing and financial analysis provided the following estimates:
Administrative costs=Rs.400000
Advertising cost=Rs.600000.
Labor cost=Rs.450/unit
Cost of parts=Rs.1000/unit

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 Demand is not known for certain and is considered probabilistic inputs. Demand is forecasted to follow
normal probability distribution with mean 500 units and standard deviation of 50 units.
Selling Price=Rs.3500/unit
PortaCom would like an analysis of the profit potential for the printer. Because of tight cash flow situation
management is particularly concerned about the potential for a loss.

Problem 3: Brown Telecommunication Services needs to determine how many telephone operators to
employ. The management at Brown estimates that the number of phone calls received each hour of a typical 8-
hour shift can be described by the following probability distribution:

Calls Probability
80 0.10
120 0.40
160 0.30
200 0.15
300 0.05
Each operator can handle 15 calls per hour and costs the company $20 per hour. Each phone call that is not
handled is assumed to cost the company $6 in lost profit. Use Simulation in Excel to determine the number of
operators that minimizes the expected hourly cost (labor plus lost profits). Run your simulation model for
1000 iterations and then make your decision.

Problem 4: You just bought an expensive car and now need to buy auto insurance. You are considering two
insurance policies, the first one has a deductible of Rs.10000 and yearly premium of Rs.820 and the second one
has a deductible of Rs.5000 and a yearly premium of Rs.1500. Each year there is a probability of 0.3 of having
an accident. The damage amount if an accident occurs follows the discrete probability distribution given
below:

Damage Amount Probability

(Rs.)
2000 0.3
4000 0.2
8000 0.1
12000 0.2
20000 0.2

Which insurance policy should you pick?

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Problem 5: You are managing the warehouse of a major retailer. Everyday truckloads of materials arrive at the
warehouse. The number of trucks arriving and the probability are given in Table 1. The daily unloading rate is
also stochastic based on the nature of the products being unloaded. The probability distribution of the daily
unloading rate is given in Table 2. Trucks are unloaded based on a first-in, first-out basis. Any truck not
unloaded the day of arrival must wait until the following day. Run a 100-day simulation model to deduce: (i)
the average number of trucks delayed, (ii) the average number of trucks unloaded each day.

Table 1:
Number of Trucks Probability
Arriving
0 0.13
1 0.17
2 0.15
3 0.25
4 0.20
5 0.10
Table 2:
Daily Unloading Probability
Rate
1 0.05
2 0.15
3 0.50
4 0.20
5 0.10

Problem 6: AOSN is an Internet Service Provider (ISP). AOSN is willing to give a customer a free PC at a
cost of $500 if the customer signs up for a guaranteed 3 years of service. During that time the cost of service to
the customer is constant at $263.40 annually. After 3 years we assume that the cost of service increases by 3%.
Without the free PC offer service cost increases by 3% from year 1. After 3 years AOSN assumes that the
probability that the customer stays with AOSN is 0.5 (retention rate). Even for without the PC offer retention
probability is 0.5. If the customer switches to another ISP there is always probability of 0.1 that the customer
(without any free PC offer) willingly joins AOSN. Even customers with the free PC can switch to other ISP
and then switch back to AOSN. Here also the switchback probability is 0.1.

AOSN wants to see whether in terms of NPV with a 10% discount rate and with an investment window of 10
years this offer makes financial sense.

(For modeling simplicity, assume that quitting and switching takes place only at the end of a year)

Problem 7: General Auto Corporation (GAC) is developing a new model of compact car. The car is assumed
to generate sales for the next 5 years. GAC has gathered information about the following quantities through
focus groups with marketing and engineering departments:

The fixed cost of manufacturing the cars is $1.9 billion. The fixed cost is incurred at the beginning of year 1,
before any sales are recorded.
Margin per car: This is the unit selling price minus the variable cost of producing a car. GAC assumes that
in year 1 the margin will be $5000. Every other year the margin will decrease by 4%.
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 The demand for the car is uncertain. GAC assumes that the demand for the cars is normally distributed
with mean 140,000 and standard deviation 30,000. Every year after that sales decreases by 5% of the sales
made in the previous year.
The discount rate is 15%.
Using a simulation model help GAC evaluate the NPV of the cash flows for this new car over the 5-year
horizon.

Problem 8: Miller Construction Company must decide whether to make a bid on a construction project. Miller
assesses that the cost to complete the project has a triangular distribution with minimum, most likely and
maximum values $9000, $10000 and $15000. The cost to prepare a bid has a triangular distribution with
parameters $300, $350 and $500. Four potential competitors are going to bid against Miller. The lowest bid
wins the contract and the winner is then given the winning bid amount to complete the project. Based on past
history, Miller believes that each potential competitor will bid, independently of the others, with probability
0.5. Miller also believes that each competitors bid will be a multiple of Millers most likely cost to complete the
project, where this multiple has a triangular distribution with minimum, most likely and maximum values 0.9,
1.3 and 1.8 respectively. If Miller decides to prepare a bid, its bid amount will be a multiple of $500 in the
range $10500 to $15000. The company wants to use simulation to determine which strategy to use to maximize
its expected profit.

Problem 9: Stock prices are estimated using Geometric Brownian Motion based on the following equation:

St 2
ln( ) ( d d )t d N (0,1) t
St 1 2

You are deliberating to buy 1000 stocks of Indian Oil Corporation Ltd (IOCL). You have collected IOCLs
stock price for the last 252 trading days (StockPriceData.xlsx). Use the historical stock prices and the above
equation to simulate stock prices of Indian Oil Corporation Ltd for the next 30 days and calculate the average
value of the investment and its standard deviation based on the simulated stock prices on day 30.

Problem 10: Develop a simulation model for a 3-year financial analysis of total profit based on the following
data and information: Sales volume in the first year is estimated to be 100,000 units and is projected to grow at
a rate that is normally distributed with a mean of 7% per year and a standard deviation of 4% per year. The
selling price is $10 in year one and the price increase is normally distributed with a mean of $0.50 and standard
deviation of $0.05 each year. Per unit variable costs are $3 in year one and is expected to increase by an amount
normally distributed with a mean of 5% per year and standard deviation of 2% per year. Fixed costs of
$200,000 are incurred annually (for the three years). Based on 1000 simulations, find the average and the
standard deviation of the 3-year cumulative profit. What is the VaR at 90% confidence level for the 3-year
cumulative profit?