Introduction to financial risk assessment using Monte Carlo simulation

The fundamental principles of financial risk assessment are discussed, with primary emphasis on using simulation to evaluate and compare alternative investments. First we introduce the key measures of performance for such investments, including net present value, internal rate of return, and modified internal rate of return. Next we discuss types of risk and the key measures of risk, including expected present value; the mean, standard deviation, and coefficient of variation of the rate of return; and the risk premium. Finally we detail the following applications: (i) stand-alone risk assessment for a capital-budgeting problem; (ii) comparison of risk-free and risky investment strategies designed merely to keep up with the cost of living; (iii) value-at-risk (VAR) analysis for a single-stock investment; (iv) VAR analyses for two-asset portfolios consisting of stock and either call or put options; and (v) VAR analyses for two-asset portfolios consisting of both puts and calls.