Financial Simulation Modeling in Excel

WHAT IS SIMULATION?

In general, simulation is typically a process that attempts to imitate how events might take place in real life. Simulations can be extraordinarily simple, such as conducting a mock interview with a peer, or incredibly complex, such as using a flight simulator to mimic a Mars landing. A simulation can also be for a tangible real-life process or for something abstract. For instance, the military often engages in simulations that try to replicate real-life war scenarios. Soldiers storm faux buildings with people playing different roles in accordance with situations they would expect in a real war. However, there are also abstract simulations such as those conducted in finance.

Even though simulations in finance may be somewhat intangible, the events that we worry about are very real. Perhaps a fund manager has a portfolio of corporate exposures. The most obvious real-life event that would be of concern is the default of one or more of these corporate exposures. Simulating defaults would be an important exercise for the fund manager to undertake. Similarly, a fixed-income specialist might invest in fixed-rate products; however, the specialist might be funded by floating rate debt returns. Basis risk exists in such a system, and the evolution of interest rates is the real-life event that the specialist would worry about. A simulation of interest rates could greatly help the specialist design a portfolio to reduce risk.