(Monte Carlo) Simulation is a specific mathematical technique whereby multiple scenarios are constructed and analysed via the generation of artificially generated random outcomes.
The model output may be an average over scenarios or a specific quantile.
Root and Branch Simulation
In order to form expectations at future timepoints the set of total scenarios S is organized in groups of root and branch scenarios .
A root scenario is a multiperiod realization of uncertainty factors that starts at the current time t=0 and extends till maturity T. A branch scenario is identical with its root scenario until a specified Risk Horizon but it then potentially branches off. Expectations at the risk horizon for each root scenario are calculated by averaging the branch scenarios
Issues and Challenges
- Simulation models may be subject to stability issues if limited by amount of available computational time.