Published On: 13/02/2022Categories: Financial Education

Simulation in investment decisions.

SIMULATION is a complex system of a fundamentally statistical nature aimed at managing uncertainty.

It uses the cash flows by means of a mathematical model in a repetitive way, establishing probability distribution of project yields.

Simulation can be one more tool among those used by the FINANCIAL DIRECTOR for making both investment and financing decisions.

Simulation performance provides an excellent basis for decision making, as the decision maker can consider a continuum of risk-return alternatives rather than a single point estimate.

The different simulation methods to analyze investment projects are normally based on the analysis of income and expenses related to the project, taking into account when they are actually received and delivered, that is, on the cash flows obtained in said project. .

MAIN SIMULATION METHODS

MONTE CARLO METHOD

The Monte Carlo method was named after the principality of Monaco for being the capital of gambling, by taking a roulette wheel as a simple random number generator.

The objective of this method is not to provide decisions but to support their decision-making.

The simulation of the Monte Carlo method is a technique that allows carrying out the valuation of investment projects considering that one, or several, of the variables used to determine the net cash flows are not certain variables, but can take on several values.

It is therefore a technique that allows risk to be introduced in the valuation of investment projects.

What is the Monte Carlo method

It is a numerical technique whose application allows calculating probabilities

Application of the Monte Carlo method

Define variables, propose scenarios, applicable in finance

Disadvantages of the Monte Carlo method

It does not provide the solution but data that serves as support for decision making

DECISION TREES

It is a technique that allows to analyze sequential decisions based on the use of results and associated probabilities.

Decision trees are diagrams that are intended to show the range of possible outcomes and subsequent decisions made after the initial decision.

In the field of artificial intelligence, it can be said that the decision tree is given by a database, on which diagrams of logical constructions are built, very similar to rule-based prediction systems, which serve to represent and categorize a series of conditions that occur successively to solve a problem.

Decision trees: advantages

One of the most useful aspects of decision trees is that they force you to consider as many possible outcomes of a decision as you can imagine.

Decision Trees: Disadvantages

One drawback of using decision trees is that subsequent outcomes, decisions, and payoffs will be largely based on expectations.

BASIC FINANCIAL TERMINOLOGY:

https://www.joaquinlopezpascual.com/glosario-de-terminos/

FINANCIAL MANAGEMENT. To know more:

TEACHING MATERIALS

https://www.joaquinlopezpascual.com/material-didactico/

BOOKS

https://www.joaquinlopezpascual.com/libros/

FINANCIAL MANAGEMENT BOOK (a classic in Spanish and Latin American Universities)

Financial Management. Financial Intelligence in Business Management.

Financial direction. Financial Intelligence in Business Management“Prentice Hall Publishers. 2ª Edición. 2006. Díez L, and López Pascual, J. ISBN 978-84-8322-351-2.

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