Financial Simulation Modeling in Excel

CHAPTER 2

Random Numbers, Distributions, and Basic Simulation Setup

When I teach financial modeling courses and introduce simulation methodologies, I often poll the class to see what people already know about simulation. Responses vary from dazed, completely blank looks, to terms such as “stochastic,” “Monte Carlo,” or “random walk.” It's the last statement, “random walk,” that seems to generate the most discussion. I suspect that this could be due to a popular book, A Random Walk Down Wall Street, in which Burton Malkiel suggests that asset prices show signs of random processes. Since a random walk or more basically, a random element, is a fundamental part of many types of financial simulations, I find it critical to start any discussion with a definition of what a random element is and how it is properly used in a financial simulation.