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Actuarial Financial Scenario Generator Project
Sponsored by the Casualty Actuarial Society and the Society of Actuaries
Kevin Ahlgrim, ASA, Bradley UniversityStephen D’Arcy, FCAS, University of Illinois
Richard Gorvett, FCAS, Zurich North America
Presented at Victoria UniversityWellington, New Zealand
February 2003
Overview of Project
CAS/SOA Request for Proposals on:
Economic Scenario Generators for Dynamic Financial Analysis and Cash Flow Testing
Goal is to provide actuaries a model for projecting economic and financial indices with realistic interdependencies among the variables.
Scope of Project
• Literature review
• Develop economic (financial) scenario generator model
• Generate scenarios over 50 year time horizon
• Document and facilitate use of model
Components of Model• Inflation
• Real interest rates
• Nominal interest rates
• Equity returns– Large stocks– Small stocks
• Equity dividend yields
• Real estate returns
• Unemployment
Inflation
One factor mean reverting process
Speed of reversion: .4
Mean reversion level: 4.8%
qtqt dBdtqdq )( (1)
Real Interest Rates
• Two factor Vasicek term structure model
• Short term rate and long term mean are both stochastic variables
222
111
)(
)(
dBdtldl
dBdtrldr
tt
ttt
r r r l l 6.1 2.8% 10.0% 5.1 10.0%
Nominal Interest Rates
Combines inflation and real interest rates
i = (1+q)x(1+r)-1
i = nominal interest rate
q = inflation
r = real interest rate
Equity Returns
• Excess equity returns (over the nominal interest rate)
• Empirical “fat tails” issue
• Regime switching model– Low volatility regime– High volatility regime
Excess Monthly Returns (1988 – 2001)
Low Volatility Regime High Volatility Regime
Large Stocks
Small Stocks Large Stocks
Small Stocks
Mean 0.6% 0.9% 0.4% -0.7%
Variance 2.2% 3.8% 4.7% 7.1%
Probability of Switching
2.7% 1.0% 2.3% 3.7%
Excess Monthly Returns (1982 – 2001) – Large Stocks Only
Low Volatility Regime High Volatility Regime
Mean 0.7% -9.0%
Variance 3.9% 8.4%
Probability of Switching
2.4% 70.4%
Unemployment
• Phillips curve– Inverse relationship between unemployment and
inflation
• First order autoregressive process
utututuut dqdtudu )(
Results• Funnel of doubt plots
• Histograms of Actual Values vs. Model Values – Inflation– Nominal interest rates
• 3 month• 1 year• 10 year
– Equity returns• Large stocks• Small stocks
• Unemployment rate
Figure 51 Year Inflation Rate (L4 to L30)
-0.06
-0.04
-0.02
0.00
0.02
0.04
0.06
0.08
0.10
0.12
L4 L6 L8 L10 L12 L14 L16 L18 L20 L22 L24 L26 L28 L30
Cell
Figure 7 Actual Inflation Rates (1913-2001)
versus Model Values
0.00
0.05
0.10
0.15
0.20
-0.1
2
-0.0
9
-0.0
6
-0.0
3
0.00
0.03
0.06
0.09
0.12
0.15
0.18
Inflation Rate
Model
Actual
Figure 11Actual 3 Month Interest Rates (1/31-6/02)
versus Model 1 Month Values
00.050.1
0.150.2
0.25
-0.2
-0.1
-0.1
-0.1 -0 0
0.03
0.06
0.09
0.12
0.15
0.18
0.21
0.24
Interest Rate
Model
Actual
Figure 12 Actual 1 Year Interest Rates (4/53-6/02)
versus Model 1 Year Interest Rates
0
0.05
0.1
0.15
0.2
-0.1 -0 -0
0.01
0.03
0.05
0.07
0.09
0.11
0.13
0.15
0.17
0.19
Interest Rate
Model
Actual
Figure 13 Actual 10 Year Interest Rates (4/54-6/02)
versus Model 20 Year Rates
00.10.20.30.40.50.6
0
0.02
0.04
0.06
0.08 0.1
0.12
0.14
0.16
0.18
Interest Rate
Model
Actual
Figure 16Actual Large Stock Returns (1871-2002)
versus Model Large Stock Returns
0
0.010.02
0.03
0.04
0.050.06
0.07
0.080.09
0.1
0.110.12
0.13
0.14
0.150.16
0.17
-0.8
-0.6
-0.5
-0.3
-0.2 0
0.15 0.3
0.45 0.6
0.75 0.9
1.05 1.2
1.35 1.5
1.65 1.8
1.95 2.1
2.25 2.4
Actual
Model
Figure 17Actual Small Stock Returns (1926-1999)
versus Model Small Stock Returns
00.020.040.060.080.1
0.120.14
-0.8
-0.5
-0.3 0
0.25 0.5
0.75 1
1.25 1.5
1.75 2
2.25
Model
Actual
Figure 21Actual Unemployment (1/48-1/02) versus Model
Unemployment Rates
0
0.05
0.1
0.15
0.2
0.25
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09 0.1
0.11
0.12
Model
Actual