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IENG 455 Fall 2015 Name_______________________

Due: August 13th (11pm, Sunday)

The grading policy for homework:


Homework turned in when due: grading starts at 100%
Homework turned in 1 day late: grading starts at 90%
Homework turned in 2 days late: grading starts at 80%...

Homework 2 (55 points)

Read the lecture notes <3.Spreadsheet SimulationOverview>, and


answer the following questions.
Put all the Excel spreadsheets in the same Excel workbook, and submit one
workbook which includes 7 different spreadsheets.

Electronic Submission: All the electronic assignments are required to be sent to the
gmail account
o Please title your email LastName_AssignmentName.
Eg., Yang_Homework3, Yang_Project2
o If technical difficulties are encountered with the gmail account, please use
the instructors email address.

1. (10 pts) Complete the exercises on random number generating functions


(RandomVariates_Ex.xls) we discussed in class. The answer would consist of 2
spreadsheets.

2. (18 pts) Complete the exercises in the file MyFinance_Ex.xls which includes 2
spreadsheets.

3. (10 pts) Complete the exercises in Comparison_Ex.xls. The answers should


include 1 spreadsheet (the last spreadsheet in file Comparison_Ex.xls).

4. (10 pts) Sam and Mary are salespeople. Sams weekly sales, X (in thousands of
dollars), are uniformly distributed between 1.0 and 5.0. Marys weekly sales, Y, have
a symmetric triangular distribution between 1.0 and 5.0. Each week Sam and Mary
compare their performance by computing the ratio X/Y. If X/Y <0.3, then Sam buys
dinner. If X/Y>0.7, then Mary buys dinner. Otherwise, they split the check. Build a

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simulation model to estimate how often Sam buys dinner and how often Mary buys
dinner. Put your answers in 1 spreadsheet.

5. (7 pts) Read the Wall Street Journal article below (attached)


Monte Carlo Simulator May Be a Good Bet for Financial Planning, By Karen
Hube. Wall Street Journal. New York, N.Y.: Apr 27, 2000. pg. C.1.
And answer the following question: What are the major advantages of Monte Carlo
Simulation (spreadsheet simulation) over the traditional approaches in financial
analysis? Put your answers in 1 spreadsheet.

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MonteCarloSimulatorMayBeaGoodBetforFinancialPlanning
ByKarenHube.WallStreetJournal.(Easternedition).NewYork,N.Y.:Apr27,2000.pg.
C.1

Abstract
No,wewouldntadviserollingdicetomakefinancialdecisionsthoughinvestorswho
haveseentherecentmovesintheNasdaqStockMarketmightdebatethat.MonteCarlo,
in this context, is the name of a financialplanning simulation that its supporters say
couldincreasetheoddsthatinvestorswillmeettheirfinancialplanninggoals.
Which is why Mr. [Christopher] Cordaro is one of the advisers who is now
toutingtheMonteCarlosimulation.Thisapproachrunsthousandsofchancescenarios
to produce probable outcomes of situations involving a number of random variables.
Thoughitisacomplexanalysisthatcantakeanhourormoretorunbycomputerand
it has its own limitations the Monte Carlo method is fast becoming one of the most
populartoolsinthefinancialplanningfield.
A number of independent financialplanning companies also are now using
MonteCarlosimulationsoftware.AndtherehavebeeninroadsontheWebbyFinancial
Engines,acompanycreatedbyNobellaureateWilliamSharpe.Othersitesarefollowing
suit. Financeware.com, Richmond, Va., offers probability analysis based on historical
returns at financialplanauditors.com, and plans to launch a second site,
wealthsimulator.com,withMonteCarlosimulationsinJune.

FullText
Wanttoimprovetheoddsofsavingenoughtoputthekidsthroughcollegeorhavea
nesteggtolastthroughretirement?

TryMonteCarlo.

No,wewouldntadviserollingdicetomakefinancialdecisionsthoughinvestorswho
haveseentherecentmovesintheNasdaqStockMarketmightdebatethat.MonteCarlo,
in this context, is the name of a financialplanning simulation that its supporters say
couldincreasetheoddsthatinvestorswillmeettheirfinancialplanninggoals.

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Manypeoplearetakingalotmoreriskthantheyrealize,saysChristopherCordaro,an
investment adviser at Bugen Stuart Korn & Cordaro, Chatham, N.J. Theyre walking
aroundwithafalsesenseofsecurity.

WhichiswhyMr.CordaroisoneoftheadviserswhoisnowtoutingtheMonteCarlo
simulation. This approach runs thousands of chance scenarios to produce probable
outcomesofsituationsinvolvinganumberofrandomvariables.Thoughitisacomplex
analysis that can take an hour or more to run by computer and it has its own
limitationstheMonteCarlomethodisfastbecomingoneofthemostpopulartoolsin
thefinancialplanningfield.
Mutualfund concern T. Rowe Price Associates Inc. has applied the Monte Carlo
technique to its recently launched Retirement Income Manager, a personalized
consultation service that helps retirees understand how much income they can afford
withoutoutlivingtheirassetsordepletingfundstheywouldliketoleavetoheirs.

A number of independent financialplanning companies also are now using Monte


Carlo simulation software. And there have been inroads on the Web by Financial
Engines,acompanycreatedbyNobellaureateWilliamSharpe.Othersitesarefollowing
suit. Financeware.com, Richmond, Va., offers probability analysis based on historical
returns at financialplanauditors.com, and plans to launch a second site,
wealthsimulator.com,withMonteCarlosimulationsinJune.

Meanwhile, a handful of software developers are marketing Monte Carlo software to


financial advisers, such as Decisioneering Inc., Denver, and Money Tree Software,
Philomath,Ore.

While any planning, even a backoftheenvelope calculation, is better than nothing,


traditionalplanningmodelsspitoutanswersthatcreatetheillusionthatthenumberis
acertainty,whenitisnt,saysRossLevin,aMinneapolisinvestmentadviserwhouses
MonteCarloanalysis.

TakeoneoftheretirementcalculatorsonIntuitInc.sQuicken.comWebsite.Afteryou
plug in information about your finances and assumptions about investment gains, the
screenshowsagreenorredlight,indicatingwhetheryouhaveenoughsavedtoretire.
Whatyoudontknowwhenitflashesgreen,however,iswhetheryouhavea95%chance
thatyourplanwillsucceedora60%chance.Howcertainareyouaboutthegreenlight
isitjustabouttoturnyellowandyouresneakingthroughthere?Mr.Cordarosays.
Jennifer Hargreaves, senior product manager of Quicken.com, says the tool isnt
programmed to analyze probability. The green light means that, based on the
information you input, if it comes true, then youll make it, she says. Its a great
startingplacetofindoutifyoureontrack.

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TheMonteCarloapproachisntperfect,either.MonteCarlomodelsareonlyasgoodas
their assumption, says Harold Evensky, a financial planner in Coral Gables, Fla., who
usesMonteCarlosimulationsforhisclients.Theprocessdoesnteliminateuncertainty.
Moreover, Monte Carlo analyses currently available online have their own limitations.
Forexample,whileFinancialEnginescanhelpyouunderstandhowmuchyouneedto
savetobuildyourretirementnestegg,itdoesnthelpyoudeterminehowlargethatnest
eggshouldbe.Investorsarelefttocomeupwiththatfigurethemselves.Theretirement
planning tools are being developed, says Jeff Maggioncalda, the sites CEO and
president.

Still,fewdisputethevaluethatprobabilityanalysiscanbringtofinancialplanning.The
MonteCarlomethodhasbeenusedbyotherindustriesfordecades.Itsprincipleswere
usedinthe1940sbyscientistsatLosAlamos,N.M.,inthemakingoftheatomicbombto
understandthebehaviorofatomicparticles.Inmorerecentyearsithasbeenappliedto
helpurbanplannerspredicttrafficpatterns,andtoinstitutionalinvestmentportfoliosto
forecastprobableoutcomes.

Mr. Levin says that with the Monte Carlo analysis software he uses Crystal Ball by
Decisioneeringherunsatleast500iterationsonasingleproblem.Heplugsinranges
foreachrandomvariable,suchasinflationisbetween2%and4%,andarateofreturn
isbetween7%and9%.

ThesoftwarebehindT.RowePricesRetirementIncomeManagerwasthreeyearsinthe
making, says spokesman Steve Norwitz. The firm charges customers $500, which
includes an initial analysis using Monte Carlo simulations and subsequent annual
reviews. The computer program takes into account eight factors that clients rate from
zeroto10inimportance,suchashavingmoneyleftforheirsandavoidingmarketrisk.
A client will receive three recommendations, each with a different probability of their
assetslastingtheirlifetimes.ThelowestprobabilityT.Rowewillrecommend:70%.

Thebiggestproblemwiththetraditionalapproachisthatitassumesfixedaveragesfor
rates of return, inflation and other variables and doesnt account for the uncertainty
inherentininvestmentplans.

Considertheperiodfrom1968to1998,whentheaverageannualreturnfortheS&P500
was11.7%.Ifaninvestorretiredin1968with$250,000andpredictedan11.7%average
annual return, he could have deduced that he would be safe withdrawing 8.5% of his
assets in his first year, then increasing his withdrawals by 3% each year, Mr. Norwitz
says.

But using the actual yearbyyear returns, he would have run out of money in 1981
becausethestockmarketperformedworsethantheassumedaverageatthestartofthe

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investors retirement. If you reverse the order of the returns starting in 1998 through
1968,theinvestorwouldhaveendedupwithfarmorethanhehadanticipated.

In the face of such widely divergent possibilities, the indepth numbers crunching
involved in a Monte Carlo simulation can bring some peace of mind. Steven Haas,
Randolph,N.J.,wasntsurewhetherhehadenoughsavedtoacceptanearlyretirement
packagefromAT&TCorp.atage53.SoheaskedMr.Cordaro.

After the financial planner concluded that Mr. Haas had a 95% probability that his
money would last until he is age 110, Mr. Hass took the package andretired. And his
wifeswitchedtoamoredesirablejobeventhoughitmeantacutinpay.

Eventhoughthenumberswererobust,IwasntconfidentIwouldbesecure,Mr.Haas
says. But I found that even under significantly negative scenarios we could live
comfortably.Itrelievedalotofanxiety.
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