Scenario Analysis, Decision Trees, And Simulation

Question 1

Steps in a simulation

Answer 1

1. Determine probabilistic variables
2. Define probability distributions for these variables
3. Check for correlations among variables
4. Run the simulation

Question 2

3 bases for defining the probability distributions for a simulation’s variables

Answer 2

Historical data, cross-sectional data, or rely on the analyst’s subjective estimation of the appropriate distribution

Question 3

When there is a strong correlation between variables used in a simulation

Answer 3

1. Allow one variable to vary and algorithmically compute the other variable
2. Build the correlation behavior into the simulation

Question 4

Advantages of using simulations in decision-making

Answer 4

1. The analyst is encouraged to more carefully estimate the inputs
2. The expected-value output takes the form of a distribution of expected value and thus is more informative than a point estimate

Question 5

Common constraints in simulations

Answer 5

1. Book value constraints
2. Earnings and cash flow constraints
3. Market value constraints

Question 6

Limitations of simulations

Answer 6

Input data quality, inappropriate specification of statistical distributions, non-stationary distributions, non-stationary (dynamic) correlations