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A quantitative risk analysis can be performed a couple of different ways. One way uses single-point estimates, or

is deterministic in nature. Using this method, an analyst may assign values for discrete scenarios to see what the

outcome might be in each. For example, in a financial model, an analyst commonly examines three different

outcomes: worst case, best case, and most likely case, each defined as follows:

Worst case scenario All costs are the highest possible value, and sales revenues are the lowest of possible

projections. The outcome is losing money.

Best case scenario All costs are the lowest possible value, and sales revenues are the highest of possible

projections. The outcome is making a lot of money.

Most likely scenario Values are chosen in the middle for costs and revenue, and the outcome shows making a

moderate amount of money.

There are several problems with this approach:

It gives equal weight to each outcome. That is, no attempt is made to assess the likelihood of each

outcome.

Interdependence between inputs, impact of different inputs relative to the outcome, and other nuances

are ignored, oversimplifying the model and reducing its accuracy.

Yet despite its drawbacks and inaccuracies, many organizations operate using this type of analysis.

A better way to perform quantitative risk analysis is by using Monte Carlo simulation. In Monte Carlo simulation,

uncertain inputs in a model are represented using ranges of possible values known as probability distributions.

By using probability distributions, variables can have different probabilities of different outcomes occurring.

Probability distributions are a much more realistic way of describing uncertainty in variables of a risk analysis.

Common probability distributions include:

Normal Or bell curve. The user simply defines the mean or expected value and a standard deviation to

describe the variation about the mean. Values in the middle near the mean are most likely to occur. It is

symmetric and describes many natural phenomena such as peoples heights. Examples of variables described

by normal distributions include inflation rates and energy prices.

Lognormal Values are positively skewed, not symmetric like a normal distribution. It is used to represent values

that dont go below zero but have unlimited positive potential. Examples of variables described by lognormal

distributions include real estate property values, stock prices, and oil reserves.

Uniform All values have an equal chance of occurring, and the user simply defines the minimum and maximum.

Examples of variables that could be uniformly distributed include manufacturing costs or future sales revenues

for a new product.

Triangular The user defines the minimum, most likely, and maximum values. Values around the most likely are

more likely to occur. Variables that could be described by a triangular distribution include past sales history per

unit of time and inventory levels.

PERT- The user defines the minimum, most likely, and maximum values, just like the triangular distribution.

Values around the most likely are more likely to occur. However values between the most likely and extremes are

more likely to occur than the triangular; that is, the extremes are not as emphasized. An example of the use of a

PERT distribution is to describe the duration of a task in a project management model.

Discrete The user defines specific values that may occur and the likelihood of each. An example might be the

results of a lawsuit: 20% chance of positive verdict, 30% change of negative verdict, 40% chance of settlement,

and 10% chance of mistrial.

During a Monte Carlo simulation, values are sampled at random from the input probability distributions. Each set

of samples is called an iteration, and the resulting outcome from that sample is recorded. Monte Carlo simulation

does this hundreds or thousands of times, and the result is a probability distribution of possible outcomes. In this

way, Monte Carlo simulation provides a much more comprehensive view of what may happen. It tells you not only

what could happen, but how likely it is to happen.

Monte Carlo simulation provides a number of advantages over deterministic analysis:

Probabilistic Results. Results show not only what could happen, but how likely each outcome is.

Graphical Results. Because of the data a Monte Carlo simulation generates, its easy to create graphs

of different outcomes and their chances of occurrence. This is important for communicating findings to

other stakeholders.

Sensitivity Analysis. With just a few cases, deterministic analysis makes it difficult to see which variables

impact the outcome the most. In Monte Carlo simulation, its easy to see which inputs had the biggest

effect on bottom-line results.

Scenario Analysis. In deterministic models, its very difficult to model different combinations of values for

different inputs to see the effects of truly different scenarios. Using Monte Carlo simulation, analysts

can see exactly which inputs had which values together when certain outcomes occurred. This is

invaluable for pursuing further analysis.

Correlation of Inputs. In Monte Carlo simulation, its possible to model interdependent relationships

between input variables. Its important for accuracy to represent how, in reality, when some factors

goes up, others go up or down accordingly.

and Project Schedules

The most common platform for performing quantitative risk analysis is the spreadsheet model. Many people still

unnecessarily use deterministic risk analysis in spreadsheet models when they could easily add Monte Carlo

simulation using @RISK in Excel. @RISK adds new functions to Excel for defining probability distributions and

analyzing output results. @RISK is also available for Microsoft Project, assessing risks in project schedules and

budgets.

by Robert Stammers,CFA (Contact Author | Biography)

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Filed Under: Financial Theory, Insurance, Options

Research analysts use multivariate models to forecast investment outcomes to understand the

possibilities surrounding their investment exposures and to better mitigate risks. Monte Carlo analysis

is one specific multivariate modeling technique that allows researchers to run multiple trials and define

all potential outcomes of an event or investment. Running a Monte Carlo model creates a probability

distribution or risk assessment for a given investment or event under review. By comparing results

against risk tolerances, managers can decide whether to proceed with certain investments or projects.

(To learn more about Monte Carlo basics, see Introduction To Monte Carlo Simulation and Monte

Carlo Simulation With GBM.)

Multivariate Models

Multivariate models can be thought of as complex, "What if?" scenarios. By changing the value of

multiple variables, the modeler can ascertain his or her impact on the estimate being evaluated.

These models are used by financial analysts to estimate cash flows and new product ideas. Portfolio

managers and financial advisors use these models to determine the impact of investments on portfolio

performance and risk. Insurance companies use these models to estimate the potential for claims and

to price policies. Some of the best-known multivariate models are those used to value stock options.

Multivariate models also help analysts determine the true drivers of value.

Monte Carlo Analysis

Monte Carlo analysis is named after the principality made famous by its casinos. With games of

chance, all the possible outcomes and probabilities are known, but with most investments the set of

future outcomes is unknown. It is up to the analyst to determine the set of outcomes and the

probability that they will occur. In Monte Carlo modeling, the analyst runs multiple trials (often

thousands) to determine all the possible outcomes and the probability that they will take place.

Monte Carlo analysis is useful for analysts because many investment and business decisions are

made on the basis of one outcome. In other words, many analysts derive one possible scenario and

then compare it to return hurdles to decide whether to proceed. Most pro forma estimates start with a

base case. By inputting the highest probability assumption for each factor, an analyst can

actually derive the highest probability outcome. However, making any decisions on the basis of a base

case is problematic, and creating a forecast with only one outcome is insufficient because it says

nothing about any other possible values that could occur. It also says nothing about the very real

chance that the actual future value will be something other than the base case prediction. It is

impossible to hedge or insure against a negative occurrence if the drivers and probabilities of these

events are not calculated in advance. (To learn more about how to manage the risk in your portfolio,

see our Risk and Diversification tutorial.)

Creating the Model

Once designed, executing a Monte Carlo model requires a tool that will randomly select factor values

that are bound by certain predetermined conditions. By running a number of trials with variables

constrained by their own independent probability of occurrence, an analyst creates a distribution that

includes all the possible outcomes and the probability that they will occur. There are many random

number generators in the marketplace. The two most common tools for designing and executing

Monte Carlo models are @Risk and Crystal Ball. Both of these can be used as add-ins for

spreadsheets and allow random sampling to be incorporated into established spreadsheet models.

The art in developing an appropriate Monte Carlo model is to determine the correct constraints for

each variable and the correct relationship between variables. For example, because portfolio

diversification is based on the correlation between assets, any model developed to create expected

portfolio values must include the correlation between investments. (To learn more, read The

Importance of Diversification.)

In order to choose the correct distribution for a variable, one must understand each of the possible

distributions available. For example, the most common one is a normal distribution, also known as a

bell curve. In a normal distribution, all the occurrences are equally distributed (symmetrical) around

the mean. The mean is the most probable event. Natural phenomena, people's heights and inflation

are some examples of inputs that are normally distributed.

In the Monte Carlo analysis, a random-number generator picks a random value for each variable

(within the constraints set by the model) and produces a probability distribution for all possible

outcomes. The standard deviation of that probability is a statistic that denotes the likelihood that the

actual outcome being estimated will be something other than the mean or most probable event.

Assuming a probability distribution is normally distributed, approximately 68% of the values will

fall within one standard deviation of the mean, about 95% of the values will fall within two standard

deviations and about 99.7 % will lie within three standard deviations of the mean. This is known as the

"68-95-99.7 rule" or the "empirical rule".

Examples

Let us take for example two separate, normally distributed probability distributions derived from

random-factor analysis or from multiple scenarios of a Monte Carlo model.

Figure 1

In both of the probability distributions (Figure 1), the expected value or base cases both equal 200.

Without having performed scenario analysis, there would be no way to compare these two estimates

and one could mistakenly conclude that they were equally beneficial. (To learn more, read Scenario

Analysis Provides Glimpse of Portfolio Potential.)

In the two probability distributions, both have the same mean but one has a standard deviation of 100,

while the other has a standard deviation of 200. This means that in the first scenario analysis there is

a 68% chance that the outcome will be some number between 100 and 300, while in the second

model there is a 68% chance that the outcome will be between 0 and 400. With all things being equal,

the one with a standard deviation of 100 has the better risk-adjusted outcome. Here, by using Monte

Carlo to derive the probability distributions, the analysis has given an investor a basis by which to

compare the two initiatives.

Monte Carlo analysis can also help determine whether certain initiatives should be taken on by

looking at the risk and return consequences of taking certain actions. Let us assume we want to place

debt on our original investment.

Figure 2

The distributions in Figure 2 show the original outcome and the outcome after modeling the effects of

leverage. Our new leveraged analysis shows an increase in the expected value from 200 to 400, but

with an increased financial risk of debt. Debt has increased the expected value by 200 but also the

standard deviation. Before 1 standard deviation was a range from 100 to 300. Now with debt, 68% of

values (1 standard deviation) fall between 0 and 400. By using scenario analysis an investor can now

determine whether the additional increase in return equals or outweighs the additional risk (variability

of potential outcomes) that comes with taking on the new initiative.

Conclusion

Monte Carlo analyses are not only conducted by finance professionals but also by many other

businesses. It is a decision-making tool that integrates the concept that every decision will have some

impact on overall risk. Every individual and institution has different risk/return tolerances. As such, it is

important that the risk/return profile of any investment be calculated and compared to risk tolerances.

The probability distributions produced by a Monte Carlo model create a picture of risk. A picture is an

easy way to convey the idea to others, such as superiors or prospective investors. Because of

advances in software, very complex Monte Carlo models can be designed and executed by anyone

with access to a personal computer.

Robert Stammers, CFA, uncovers and analyzes stock and option trading opportunities as a senior

equity analyst at stock market education company BetterTrades. Previously, he was portfolio manager

for a $1 billion enhanced real estate fund, a public timber fund and multiple pension fund separate

accounts, while acting as a senior executive for several institutional fund managers. Mr. Stammers

holds The CFA Institute's Chartered Financial Analyst designation, a Bachelor of Arts in economics

from Connecticut College, and a Master of Business Administration with honors from Emory

University. Visit Bettertrades.com to learn more timely strategies and tactics for creating cash flow

with stocks and options.

In discrete compounded rates of return, time moves forward in increments, with each increment

having a rate of return (ending price / beginning price) equal to 1. Of course, the more frequent the

compounding, the higher the rate of return. Take a security that is expected to return 12% annually:

With quarterly holding periods, 3% compounded 4 times = (1.03) 4 - 1 = 12.55%

With monthly holding periods, 1% compounded 12 times = (1.01) 12 - 1 = 12.68%

With daily holding periods, (12/365) compounded 365 times = 12.7475%

With hourly holding periods, (12/(365*24) compounded (365*24) times = 12.7496%

With greater frequency of compounding (i.e. as holding periods become smaller and smaller) the

effective rate gradually increases but in smaller and smaller amounts. Extending this further, we can

reduce holding periods so that they are sliced smaller and smaller so they approach zero, at which

point we have the continuously compounded rate of return. Discrete compounding relates to

measurable holding periods and a finite number of holding periods. Continuous compounding relates

to holding periods so small they cannot be measured, with frequency of compounding so large it goes

to infinity.

The continuous rate associated with a holding period is found by taking the natural log of 1 + holdingperiod return) Say the holding period is one year and holding-period return is 12%:

ln (1.12) = 11.33% (approx.)

In other words, if 11.33% were continuously compounded, its effective rate of return would be about

12%.

Earlier we found that 12% compounded hourly comes to about 12.7496%. In fact, e (the

transcendental number) raised to the 0.12 power yields 12.7497% (approximately).

As we've stated previously, actual calculations of natural logs are not likely for answering a question

as they give an unfair advantage to those with higher function calculators. At the same time, an exam

problem can test knowledge of a relationship without requiring the calculation. For example, a

question could ask:

Q. A portfolio returned 5% over one year, if continuously compounded, this is equivalent to

____?

A. ln 5

B. ln 1.05

C. e5

D. e1.05

The answer would be B based on the definition of continuous compounding. A financial function

calculator or spreadsheet could yield the actual percentage of 4.879%, but wouldn't be necessary to

answer the question correctly on the exam.

Monte Carlo Simulation

A Monte Carlo Simulation refers to a computer-generated series of trials where the probabilities for

both risk and reward are tested repeatedly in an effort to help define these parameters. These

simulations are characterized by large numbers of trials - typically hundreds or even thousands of

iterations, which is why it's typically described as "computer generated". Also know that Monte Carlo

simulations rely on random numbers to generate a series of samples.

Monte Carlo simulations are used in a number of applications, often as a complement to other riskassessment techniques in an effort to further define potential risk. For example, a pension-benefit

administrator in charge of managing assets and liabilities for a large plan may use computer software

with Monte Carlo simulation to help understand any potential downside risk over time, and how

changes in investment policy (e.g. higher or lower allocations to certain asset classes, or the

introduction of a new manager) may affect the plan. While traditional analysis focuses on returns,

variances and correlations between assets, a Monte Carlo simulation can help introduce other

pertinent economic variables (e.g. interest rates, GDP growth and foreign exchange rates) into the

simulation.

Monte Carlo simulations are also important in pricing derivative securities for which there are no

existing analytical methods. European- and Asian-style options are priced with Monte Carlo methods,

as are certain mortgage-backed securities for which the embedded options (e.g. prepayment

assumptions) are very complex.

A general outline for developing a Monte Carlo simulation involves the following steps (please note

that we are oversimplifying a process that is often highly technical):

1. Identify all variables about which we are interested, the time horizon of the analysis and the

distribution of all risk factors associated with each variable.

2. Draw K random numbers using a spreadsheet generator. Each random variable would then

be standardized so we have Z1, Z2, Z3... ZK.

3. Simulate the possible values of the random variable by calculating its observed value with Z 1,

Z2, Z3... ZK.

4. Following a large number of iterations, estimate each variable and quantity of interest to

complete one trial. Go back and complete additional trials to develop more accurate

estimates.

Historical Simulation

Historical simulation, or back simulation, follows a similar process for large numbers of iterations, with

historical simulation drawing from the previous record of that variable (e.g. past returns for a mutual

fund). While both of these methods are very useful in developing a more meaningful and in-depth

analysis of a complex system, it's important to recognize that they are basically statistical estimates;

that is, they are not as analytical as (for example) the use of a correlation matrix to understand

portfolio returns. Such simulations tend to work best when the input risk parameters are well defined.

by David Harper,CFA, FRM (Contact Author | Biography)

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Filed Under: Financial Theory

One of the most common ways to estimate risk is the use of a Monte Carlo simulation (MCS). For

example, to calculate the value at risk (VaR) of a portfolio, we can run a Monte Carlo simulation that

attempts to predict the worst likely loss for a portfolio given a confidence interval over a specified time

horizon - we always need to specify two conditions for VaR: confidence and horizon. (For related

reading, see The Uses And Limits Of Volatility and Introduction To Value At Risk (VAR) - Part 1 and

Part 2.)

need a model to specify the behavior of the stock price, and we'll use one of the most common

models in finance: geometric Brownian motion (GBM). Therefore, while Monte Carlo simulation can

refer to a universe of different approaches to simulation, we will start here with the most basic.

Where to Start

A Monte Carlo simulation is an attempt to predict the future many times over. At the end of the

simulation, thousands or millions of "random trials" produce a distribution of outcomes that can be

analyzed. The basics steps are:

1. Specify a model (e.g. geometric Brownian motion)

2. Generate random trials

3. Process the output

1. Specify a Model (e.g. GBM)

In this article, we will use the geometric Brownian motion (GBM), which is technically a Markov

process. This means that the stock price follows a random walk and is consistent with (at the very

least) the weak form of the efficient market hypothesis (EMH): past price information is already

incorporated and the next price movement is "conditionally independent" of past price movements.

(For more on EMH, read Working Through The Efficient Market Hypothesis and What Is Market

Efficiency?)

The formula for GBM is found below, where "S" is the stock price, "m" (the Greek mu) is the expected

return, "s" (Greek sigma) is the standard deviation of returns, "t" is time, and "e" (Greek epsilon) is the

random variable:

If we rearrange the formula to solve just for the change in stock price, we see that GMB says the

change in stock price is the stock price "S" multiplied by the two terms found inside the parenthesis

below:

The first term is a "drift" and the second term is a "shock". For each time period, our model assumes

the price will "drift" up by the expected return. But the drift will be shocked (added or subtracted) by a

random shock. The random shock will be the standard deviation "s" multiplied by a random number

"e". This is simply a way of scaling the standard deviation.

That is the essence of GBM, as illustrated in Figure 1. The stock price follows a series of steps, where

each step is a drift plus/minus a random shock (itself a function of the stock's standard deviation):

Figure 1

2. Generate Random Trials

Armed with a model specification, we then proceed to run random trials. To illustrate, we've used

Microsoft Excel to run 40 trials. Keep in mind that this is an unrealistically small sample; most

simulations or "sims" run at least several thousand trials.

In this case, let's assume that the stock begins on day zero with a price of $10. Here is a chart of the

outcome where each time step (or interval) is one day and the series runs for ten days (in summary:

forty trials with daily steps over ten days):

The result is forty simulated stock prices at the end of 10 days. None has happened to fall below $9,

and one is above $11.

3. Process the Output

The simulation produced a distribution of hypothetical future outcomes. We could do several things

with the output. If, for example, we want to estimate VaR with 95% confidence, then we only need to

locate the thirty-eighth-ranked outcome (the third-worst outcome). That's because 2/40 equals 5%, so

the two worst outcomes are in the lowest 5%.

If we stack the illustrated outcomes into bins (each bin is one-third of $1, so three bins covers the

interval from $9 to $10), we'll get the following histogram:

Figure 3

Remember that our GBM model assumes normality: price returns are normally distributed with

expected return (mean) "m" and standard deviation "s". Interestingly, our histogram isn't looking

normal. In fact, with more trials, it will not tend toward normality. Instead, it will tend toward a

lognormal distribution: a sharp drop off to the left of mean and a highly skewed "long tail" to the right

of the mean. This often leads to a potentially confusing dynamic for first-time students:

Price returns are normally distributed.

Price levels are log-normally distributed.

Think about it this way: A stock can return up or down 5% or 10%, but after a certain period of time,

the stock price cannot be negative. Further, price increases on the upside have a compounding effect,

while price decreases on the downside reduce the base: lose 10% and you are left with less to lose

the next time. Here is a chart of the lognormal distribution superimposed on our illustrated

assumptions (e.g. starting price of $10):

Figure 4

Summary

A Monte Carlo simulation applies a selected model (a model that specifies the behavior of an

instrument) to a large set of random trials in an attempt to produce a plausible set of possible future

outcomes. In regard to simulating stock prices, the most common model is geometric Brownian

motion (GBM). GBM assumes that a constant drift is accompanied by random shocks. While the

period returns under GBM are normally distributed, the consequent multi-period (for example, ten

days) price levels are lognormally distributed.

Check out David Harper's movie tutorial, Monte Carlo Simulation with Geometric Brownian Motion, to

learn more on this topic.

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a

site that trains professionals in advanced and career-related finance, including financial certification.

David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth

and technology value) led to superior outperformance (+35% in the first year) with minimal risk and

helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting

(derivatives valuation), litigation support and financial education.

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It is important to keep in mind that when a company analyzes a potential project, it is forecasting

potential not actual cash flows for a project. As we all know, forecasts are based on assumptions that

may be incorrect. It is therefore important for a company to perform a sensitivity analysis on its

assumptions to get a better sense of the overall risk of the project the company is about to take.

There are three risk-analysis techniques that should be known for the exam:

1.Sensitivity analysis

2.Scenario analysis

3.Monte Carlo simulation

1.Sensitivity Analysis

Sensitivity analysis is simply the method for determining how sensitive our NPV analysis is to changes

in our variable assumptions. To begin a sensitivity analysis, we must first come up with a base-case

scenario. This is typically the NPV using assumptions we believe are most accurate. From there, we

can change various assumptions we had initially made based on other potential assumptions. NPV is

then recalculated, and the sensitivity of the NPV based on the change in assumptions is determined.

Depending on our confidence in our assumptions, we can determine how potentially risky a project

can be.

2.Scenario Analysis

Scenario analysis takes sensitivity analysis a step further. Rather than just looking at the sensitivity of

our NPV analysis to changes in our variable assumptions, scenario analysis also looks at the

probability distribution of the variables. Like sensitivity analysis, scenario analysis starts with the

construction of a base case scenario. From there, other scenarios are considered, known as the

"best-case scenario" and the "worst-case scenario". Probabilities are assigned to the scenarios and

computed to arrive at an expected value. Given its simplicity, scenario analysis is one the most

3.Monte Carlo Simulation

Monte Carlo simulationis considered to be the "best" method of sensitivity analysis. It comes up with

infinite calculations (expected values) given a number of constraints. Constraints are added and the

system generates random variables of inputs. From there, NPV is calculated. Rather than generating

just a few iterations, the simulation repeats the process numerous times. From the numerous results,

the expected value is then calculated

Stochastic Modeling

What Does Stochastic Modeling Mean?

A method of financial modeling in which one or more variables within the model are random.

Stochastic modeling is for the purpose of estimating the probability of outcomes within a forecast

to predict what conditions might be like under different situations. The random variables are usually

constrained by historical data, such as past market returns.

The Monte Carlo Simulation is an example of a stochastic model used in finance. When used in

portfolio evaluation, multiple simulations of the performance of the portfolio are done based on the

probability distributions of the individual stock returns. A statistical analysis of the results can then help

determine the probability that the portfolio will provide the desired performance.

Quantitative Analysis

What Does Quantitative Analysis Mean?

A business or financial analysis technique that seeks to understand behavior by using complex

mathematical and statistical modeling, measurement and research. By assigning a numerical value to

variables, quantitative analysts try to replicate reality mathematically.

Quantitative analysis can be done for a number of reasons such as measurement, performance

evaluation or valuation of a financial instrument. It can also be used to predict real world events such

as changes in a share price.

In broad terms, quantitative analysis is simply a way of measuring things. Examples of quantitative

analysis include everything from simple financial ratios such as earnings per share, to something as

complicated as discounted cash flow, or option pricing.

Although quantitative analysis is a powerful tool for evaluating investments, it rarely tells a complete

story without the help of its opposite - qualitative analysis. In financial circles, quantitative analysts are

affectionately referred to as "quants", "quant jockeys" or "rocket scientists".

What Does Monte Carlo Simulation Mean?

A problem solving technique used to approximate the probability of certain outcomes by running

multiple trial runs, called simulations, using random variables.

Monte Carlo simulation is named after the city in Monaco, where the primary attractions are casinos

that have games of chance. Gambling games, like roulette, dice, and slot machines, exhibit random

behavior.

Bell Curve

What Does Bell Curve Mean?

The most common type of distribution for a variable. The term "bell curve" comes from the fact that

the graph used to depict a normal distribution consists of a bell-shaped line.

The bell curve is also known as a normal distribution. The bell curve is less commonly referred to as a

Gaussian distribution, after German mathematician and physicist Karl Gauss, who popularized the

model in the scientific community by using it to analyze astronomical data.

The highest point in the curve, or the top of the bell, represents the most probable event. All possible

occurrences are equally distributed around the most probable event, which creates a downwardsloping line on each side of the peak.

Filed Under: Forex, Technical Analysis

Related Terms

Mean

Monte Carlo Simulation

Normal Distribution

Statistics

Variability

Venn Diagram

More Related Terms

Mean

The simple mathematical average of a set of two or more numbers. The mean for a given set of

numbers can be computed in more than one way, including the arithmetic mean method, which uses

the sum of the numbers in the series, and the geometric mean method. However, all of the primary

methods for computing a simple average of a normal number series produce the same approximate

result most of the time.

If stock XYZ closed at $50, $51 and $54 over the past three days, the arithmetic mean would be the

sum of those numbers divided by three, which is $51.67.

In contrast, the geometric mean would be computed as third root of the numbers' product, or the third

root of 137,700, which approximately equals $51.64. While the two numbers are not exactly equal,

most people consider arithmetic and geometric means to be equivalent for everyday purposes.

Arithmetic Mean

What Does Arithmetic Mean Mean?

A mathematical representation of the typical value of a series of numbers, computed as the sum of all

the numbers in the series divided by the count of all numbers in the series.

Arithmetic mean is commonly referred to as "average" or simply as "mean".

Suppose you wanted to know what the arithmetic mean of a stock's closing price was over the past

week. If during the five-day week the stock closed at $14.50, $14.80, $15.20, $15.50, and then

$14.00, its arithmetic mean closing price would be equal to the sum of the five numbers ($74.00)

divided by five, or $14.80

Winsorized Mean

What Does Winsorized Mean Mean?

A method of averaging that initially replaces the smallest and largest values with the observations

closest to them. After replacing the values, a simple arithmetic averaging formula is used to calculate

the winsorized mean.

Winsorized means are expressed in two ways. A "kth" winsorized mean refers to the replacement of

the 'k' smallest and largest observations, where 'k' is an integer. A "X%" winsorized mean involves

replacing a given percentage of values from both ends of the data.

The winsorized mean is less sensitive to outliers because it replaces them with less influential values.

This method of averaging is similar to the trimmed mean; however, instead of eliminating data,

observations are altered, allowing for a degree of influence.

Let's calculate the first winsorized mean for the following data set: 1, 5, 7, 8, 9, 10, 14. Because the

winsorized mean is in the first order, we replace the smallest and largest values with their nearest

observations. The data set now appears as follows: 5, 5, 7, 8, 9, 10, 10. Taking an arithmetic average

of the new set produces a winsorized mean of 7.71 ( (5+5+7+8+9+10+10) / 7 ).

Geometric Mean

What Does Geometric Mean Mean?

The average of a set of products, the calculation of which is commonly used to determine the

performance results of an investment or portfolio. Technically defined as "the 'n'th root product of 'n'

numbers", the formula for calculating geometric mean is most easily written as:

The geometric mean must be used when working with percentages (which are derived from values),

whereas the standard arithmetic mean will work with the values themselves.

The main benefit to using the geometric mean is that the actual amounts invested do not need to be

known; the calculation focuses entirely on the return figures themselves and presents an "apples-toapples" comparison when looking at two investment options.

Average Price

What Does Average Price Mean?

1. A representative measure of a range of prices that is calculated by taking the sum of the values and

dividing it by the number of prices being examined. The average price reduces the range into a

single value, which can then be compared to any point to determine if the value is higher or lower than

what would be expected.

2. A bond's average price is calculated by adding its face value to the price paid for it and dividing the

sum by two. The average price is sometimes used in determining a bond's yield to maturity where the

average price replaces the purchase price in the yield to maturity calculation.

1. In situations where there is a range of prices it can be useful to calculate the average price to

simplify a range of numbers into a single value. For example, if over a four-month period you paid

$104, $105, $110, and $115 for your utilities, the average price or cost of your monthly utilities would

be $108.50.

2. Although the average price of a bond is not the most accurate method to find its YTM, it does give

investors a rough and simple gauge to find out what a bond is worth.

Moving Average - MA

An indicator frequently used in technical analysis showing the average value of a security's price over

a set period. Moving averages are generally used to measure momentum and define areas of

possible support and resistance.

Moving averages are used to emphasize the direction of a trend and to smooth out price and volume

fluctuations, or "noise", that can confuse interpretation. Typically, upward momentum is confirmed

when a short-term average (e.g.15-day) crosses above a longer-term average (e.g. 50-day).

Downward momentum is confirmed when a short-term average crosses below a long-term average.

What Does Exponential Moving Average - EMA Mean?

A type of moving average that is similar to a simple moving average, except that more weight is given

to the latest data. The exponential moving average is also known as "exponentially weighted moving

average".

This type of moving average reacts faster to recent price changes than a simple moving average. The

12- and 26-day EMAs are the most popular short-term averages, and they are used to create

indicators like the moving average convergence divergence (MACD) and the percentage price

oscillator (PPO). In general, the 50- and 200-day EMAs are used as signals of long-term trends.

What Does Double Exponential Moving Average - DEMA Mean?

A technical indicator developed by Patrick Mulloy that first appeared in the February, 1994 Technical

Analysis of Stocks & Commodities. The DEMA is a calculation based on both a single exponential

moving average (EMA) and a double EMA.

The DEMA is a fast-acting moving average that is more responsive to market changes than a

traditional moving average. It was developed in an attempt to create a calculation that eliminated

some of the lag associated with traditional moving averages. The DEMA can be used as a standalone indicator and can be incorporated into other technical analysis tools whose logic are based on

moving averages.

What Does Simple Moving Average - SMA Mean?

A simple, or arithmetic, moving average that is calculated by adding the closing price of the security

for a number of time periods and then dividing this total by the number of time periods. Short-term

averages respond quickly to changes in the price of the underlying, while long-term averages are slow

to react.

In other words, this is the average stock price over a certain period of time. Keep in mind that equal

weighting is given to each daily price. As shown in the chart above, many traders watch for short-term

averages to cross above longer-term averages to signal the beginning of an uptrend. As shown by the

blue arrows, short-term averages (e.g. 15-period SMA) act as levels of support when the price

experiences a pullback. Support levels become stronger and more significant as the number of time

periods used in the calculations increases.

Generally, when you hear the term "moving average", it is in reference to a simple moving average.

This can be important, especially when comparing to an exponential moving average (EMA).

A type of moving average that assigns a higher weighting to recent price data than does the common

simple moving average. This average is calculated by taking each of the closing prices over a given

time period and multiplying them by its certain position in the data series. Once the position of the

time periods have been accounted for they are summed together and divided by the sum of the

number of time periods.

For example, in a 15-day linearly-weighted moving average, today's closing price is multiplied by 15,

yesterday's by 14, and so on until day 1 in the period's range is reached. These results are then

added together and divided by the sum of the multipliers (15 + 14 + 13 + ... + 3 + 2 + 1 = 120).

The linearly weighted moving average was one of the first responses to placing a greater importance

on recent data. The popularity of this moving average has been diminished by the exponential moving

average, but none the less it still proves to be very useful

Figures or components that are adjusted to reflect importance by value or proportion.

Commonly used as a method to assign a value, based on proportion, to various securities within a

given index. For example, the DJIA weighs each security based on the stock's price relative to the

sum of all the stock prices. The Nasdaq on the other hand, is a market capitalization weighted index

with each company weighting being proportionate to its market value.

Weighted Average

What Does Weighted Average Mean?

An average in which each quantity to be averaged is assigned a weight. These weightings determine

the relative importance of each quantity on the average. Weightings are the equivalent of having that

many like items with the same value involved in the average.

To demonstrate, let's take the value of letter tiles in the popular game Scrabble.

Value:

10

Occurrences: 2

8

2

5

1

4

10

3

8

2

7

1

68

0

2

To average these values, do a weighted average using the number of occurrences of each value as

the weight. To calculate a weighted average:

1. Multiply each value by its weight. (Ans: 20, 16, 5, 40, 24, 14, 68, and 0)

2. Add up the products of value times weight to get the total value. (Ans: Sum=187)

3. Add the weight themselves to get the total weight. (Ans: Sum=100)

4. Divide the total value by the total weight. (Ans: 187/100 = 1.87 = average value of a Scrabble

tile)

Price-Weighted Index

What Does Price-Weighted Index Mean?

A stock index in which each stock influences the index in proportion to its price per share. The value

of the index is generated by adding the prices of each of the stocks in the index and dividing them by

the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will

have a greater influence over the performance of the index.

For example, assume that an index contains only two stocks, one priced at $1 and one priced at $10.

The $10 stock is weighted nine times higher than the $1 stock. Overall, this means that this index is

composed of 90% of the $10 stocks and 10% of $1 stock.

In this case, a change in the value of the $1 stock will not affect the index's value by a large amount,

because it makes up such a small percentage of the index.

A popular price-weighted stock market index is the Dow Jones Industrial Average. It includes a priceweighted average of 30 actively traded blue chip stocks.

What Does Dow Jones Industrial Average - DJIA Mean?

The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the

New York Stock Exchange and the Nasdaq. The DJIA was invented by Charles Dow back in 1896.

Often referred to as "the Dow", the DJIA is the oldest and single most watched index in the world. The

DJIA includes companies like General Electric, Disney, Exxon and Microsoft.

When the TV networks say "the market is up today", they are generally referring to the Dow.

What Does Weighted Average Cost of Equity - WACE Mean?

A way to calculate the cost of a company's equity that gives different weight to different aspects of the

equities. Instead of lumping retained earnings, common stock, and preferred stock together, WACE

provides a more accurate idea of a companies total cost of equity. Determining an accurate cost of

equity for a firm is integral for the firm to be able to calculate its cost of capital.

In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future

project will be profitable or not.

Here is an example of how to calculate the WACE:

First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained

earnings. Lets assume we have already done this and the cost of common stock, preferred stock and

retained earnings are 24%, 10% and 20% respectively.

Now, you must calculate the portion of total equity that is occupied by each form of equity. Again, lets

assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings

respectively.

Finally, you multiply the cost of each form of equity by its respective portion of total equity and sum of

the values - which results in the WACE. Our example results in a WACE of 19.5%.

WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%

What Does Weighted Average Market Capitalization Mean?

A stock market index weighted by the market capitalization of each stock in the index. In such a

weighting scheme, larger companies account for a greater portion of the index. Most indexes are

constructed in this manner, with the best example being the S&P 500.

For example, if a company's market capitalization is $1 million and the market capitalization of all

stocks in the index is $100 million, then the company would be worth 1% of the index. The alternative

to weighting by market cap is a price-weighted index such as the Dow Jones Industrial Average.

Capitalization-Weighted Index

What Does Capitalization-Weighted Index Mean?

A type of market index whose individual components are weighted according to their market

capitalization, so that larger components carry a larger percentage weighting. The value of a

capitalization-weighted index can be computed by adding up the collective market capitalizations of its

members and dividing it by the number of securities in the index.

Also known as a "market-value weighted index".

Most of the broadly-used market indexes today are "cap-weighted" indexes, such as the S&P 500,

Nasdaq, Wilshire, Hang-Seng and EAFE indexes. In a cap-weighted index, large price moves in the

largest components can have a dramatic effect on the value of the index. Some investors feel that this

overweighting toward the larger companies gives a distorted view of the market, but the fact that the

largest companies also have the largest shareholder bases makes the case for having the higher

relevancy in the index.

What Does Standard & Poor's 500 Index - S&P 500 Mean?

An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors.

The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the

risk/return characteristics of the large cap universe.

Companies included in the index are selected by the S&P Index Committee, a team of analysts and

economists at Standard & Poor's. The S&P 500 is a market value weighted index - each stock's

weight is proportionate to its market value.

The S&P 500 is one of the most commonly used benchmarks for the overall U.S. stock market. The

Dow Jones Industrial Average (DJIA) was at one time the most renowned index for U.S. stocks, but

because the DJIA contains only 30 companies, most people agree that the S&P 500 is a better

representation of the U.S. market. In fact, many consider it to be the definition of the market.

Other popular Standard & Poor's indexes include the S&P 600, an index of small cap companies

with market capitalizations between $300 million and $2 billion, and the S&P 400, an index of mid cap

companies with market capitalizations of $2 billion to $10 billion.

A number of financial products based on the S&P 500 are available to investors. These include index

funds and exchange-traded funds. However, it would be difficult for individual investors to buy the

index, as this would entail buying 500 different stocks.

Free-Float Methodology

What Does Free-Float Methodology Mean?

A method by which the market capitalization of an index's underlying companies is calculated. Freefloat methodology market capitalization is calculated by taking the equity's price and multiplying it by

the number of shares readily available in the market. Instead of using all of the shares outstanding like

the full-market capitalization method, the free-float method excludes locked-in shares such as those

held by promoters and governments.

Calculated as:

The free-float method is seen as a better way of calculating market capitalization because it provides

a more accurate reflection of market movements. When using a free-float methodology, the resulting

market capitalization is smaller than what would result from a full-market capitalization method.

Free-float methodology has been adopted by most of the world's major indexes, including the Dow

Jones Industrial Average and the S&P 500.

Nasdaq

What Does Nasdaq Mean?

A computerized system that facilitates trading and provides price quotations on more than 5,000 of

the more actively traded over the counter stocks. Created in 1971, the Nasdaq was the world's first

electronic stock market.

Stocks on the Nasdaq are traditionally listed under four or five letter ticker symbols. If the company is

a transfer from the New York Stock Exchange, the symbol may be comprised of three letters.

The term "Nasdaq" used to be capitalized "NASDAQ" as an acronym for National Association of

Securities Dealers Automated Quotation. The acronym is no longer used and Nasdaq is now a proper

noun.

The Nasdaq is traditionally home to many high-tech stocks, such as Microsoft, Intel, Dell and Cisco.

What is the difference between the Dow and the Nasdaq?

Because of the way people throw around the words "Dow" and "Nasdaq," both terms have

become synonymous with "the market," giving people a hazy idea of what each term actually

means. In this question, "the Dow" refers to the famous figure that peppers almost all business

news reports: the Dow Jones Industrial Average (DJIA), an important index that many people

watch to get an indication of how well the overall stock market is performing. The Dow, or the

DJIA, is not exactly the same as Dow Jones and Company, the firm that publishes the Wall

Street Journal. However,the editors of the Wall Street Journal are the people who maintain the

DJIA, along with other Dow Jones indices. The Nasdaq is also a term that can refer to two

different things: first, it is the National Association of Securities Dealers Automated Quotations

System, which is the first electronic exchange, where investors can buy and sell stock. Second,

when you hear people say that the "the Nasdaq is up today," they are referring to the Nasdaq

Composite Index, which, like the DJIA, is a statistical measure of a portion of the market.

Both the Dow and the Nasdaq, then, refer to an index, or an average of a bunch of numbers

derived from the price movements of certain stocks. The DJIA tracks the performance of 30

different companies that are considered major players in their industries. The Nasdaq Composite,

on the other hand, tracks approximately 4,000 stocks, all of which are traded on the Nasdaq

exchange. The DJIA is composed mainly of companies found on the NYSE, with only a couple of

Nasdaq-listed stocks.

Remember, although both "the Dow" and the "Nasdaq" refer to market indices, only the Nasdaq

also refers to an exchange where investors can buy and sell stock. Furthermore, an investor can't

trade the Dow or the Nasdaq indexes because they each represent merely a mathematical

average that people use to try and make sense of the stock market. You can, however, purchase

index funds, which are a kind of mutual fund, or exchange traded funds, which are securities that

track the indexes.

Blue Chip

A nationally recognized, well-established and financially sound company. Blue chips generally sell

high-quality, widely accepted products and services. Blue chip companies are known to weather

downturns and operate profitably in the face of adverse economic conditions, which helps to

contribute to their long record of stable and reliable growth.

The name "blue chip" came about because in the game of poker the blue chips have the highest

value.

Blue chip stocks are seen as a less volatile investment than owning shares in companies without blue

chip status because blue chips have an institutional status in the economy. Investors may buy blue

chip companies to provide steady growth in their portfolios. The stock price of a blue chip usually

closely follows the S&P 500.

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