9717

Simulating the IRR

Monte Carlo simulation is useful when actual data does not exist or is hard to acquire. Many simulations are conducted for the purposes of predicting the mean or forming a probability distribution. The real estate analyst, often faced with a paucity of data, is tempted to simulate the internal rate of return (IRR) for a project. However, simulation introduces inaccuracies because of Jensen's inequality. Operationally, the problem arises from the curved nature of the IRR function. Simulation uses the concept of the expectation, which is a linear operator. Calculating an expectation for a curved function is a form of linear interpolation that has a built-in error to the extent the straight line between two points does not coincide with the curve. This Demonstration refers to this error as a bias.
Fortunately, the bias is small. But for large sums of money, even an error of few basis points in yield can make a large difference in nominal dollars. More importantly, the amount of the bias grows with the variation. The bias is only zero when there is no variation, a situation rendering simulation unnecessary. Conversely, when variation is great, the bias is also large, making simulation less accurate the more one needs it. The analyst is well advised to consider instead simulating the net present value, which under the right circumstances can be a linear function of cash flow, so that its simulation does not produce misleading conclusions.
This Demonstration uses a stylized set of cash flows in which intertemporal cash flows are fixed and the relationship between initial investment and the net sale proceeds can be reversed. In the equation below the IRR is the root of the equation when .
Jensen's theorem affects concave and convex functions equally (the difference in his conclusion, shown below, is the reversal of the inequality sign). The curve of the IRR changes between convex and concave based on the timing and size of the cash flows, producing an infinite number of error forms matching the infinite number of possible cash flow variations.
  • Contributed by: Roger J. Brown
  • Reproduced by permission of Academic Press from Private Real Estate Investment ©2005

THINGS TO TRY

SNAPSHOTS

  • [Snapshot]
  • [Snapshot]
  • [Snapshot]

DETAILS

J. L. W. V. Jensen, "Sur les fonctions convexes et les inégalités entre les valeurs moyennes," Acta Math., 30, 1906 pp. 175–193.
Jensen's inequality holds that a function is convex in the interval if and only if the following inequality is satisfied for all in and for all with : . A common description of this theorem would be that the function of the expectation is always less than or equal to the expectation of the function. The bias described in this Demonstration is a measure of how these two differ. The bias direction will depend on whether the function is convex or concave (resulting in "less than or equal to…" becoming "equal to or more than…" in the statement above).
R. J. Brown, "Sins of the IRR," The Journal of Real Estate Portfolio Management, 12(2), 2006 pp. 195-200.
More information is available in Chapter Four of Private Real Estate Investment and at mathestate.com.
R. J. Brown, Private Real Estate Investment: Data Analysis and Decision Making, Burlington, MA: Elsevier Academic Press, 2005.

PERMANENT CITATION

Contributed by: Roger J. Brown
Reproduced by permission of Academic Press from Private Real Estate Investment ©2005
    • Share:

Embed Interactive Demonstration New!

Just copy and paste this snippet of JavaScript code into your website or blog to put the live Demonstration on your site. More details »

Files require Wolfram CDF Player or Mathematica.









 
RELATED RESOURCES
Mathematica »
The #1 tool for creating Demonstrations
and anything technical.
Wolfram|Alpha »
Explore anything with the first
computational knowledge engine.
MathWorld »
The web's most extensive
mathematics resource.
Course Assistant Apps »
An app for every course—
right in the palm of your hand.
Wolfram Blog »
Read our views on math,
science, and technology.
Computable Document Format »
The format that makes Demonstrations
(and any information) easy to share and
interact with.
STEM Initiative »
Programs & resources for
educators, schools & students.
Computerbasedmath.org »
Join the initiative for modernizing
math education.
Step-by-step Solutions »
Walk through homework problems one step at a time, with hints to help along the way.
Wolfram Problem Generator »
Unlimited random practice problems and answers with built-in Step-by-step solutions. Practice online or make a printable study sheet.
Wolfram Language »
Knowledge-based programming for everyone.
Powered by Wolfram Mathematica © 2014 Wolfram Demonstrations Project & Contributors  |  Terms of Use  |  Privacy Policy  |  RSS Give us your feedback
Note: To run this Demonstration you need Mathematica 7+ or the free Mathematica Player 7EX
Download or upgrade to Mathematica Player 7EX
I already have Mathematica Player or Mathematica 7+