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Week 10
Asset Liability Models
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Real GDP
Price Inflation
Earnings Yield
Earnings Growth
Currency Strength
Credit Spreads
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q
where
q
k
t+1
= q +kq
t
( q ) t +
q
is inflation in period t
q is the mean reversion parameter
q is the mean reversion level of inflation
is a normal random variate N(0,1)
is the volatility of inflation
t
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= q + r t + (r t r t1) + + e t
t1
e = pe
t
where r
t1
2
t1
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Regime-switching models
Rather than one pair of parameters (, ) to describe the
return distribution, we think of a different distribution for
each regime
Example
Regime 1 : Positive expected return, moderate volatility
Regime 2 : Negative expected return, high volatility
Markov switching between regimes probability of
changing regime depends only on the current regime, not
history
Use maximum likelihood to estimate (, ) for each regime
and the two probabilities of remaining in each
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Market Consistency
Generally economic scenario generators are not too
concerned with current market consistency (eg volatility
of equity returns aligning with implied volatility of index
options) as horizon lengthens
Instead calibration focuses on consistency with how
markets behave over time
For example current bond yields are low compared to
history and equilibrium real yields so the ESG may
contemplate them drifting upward over time
An ESG is attempting to be realistic over a medium term
horizon, not just the next year
Focus is on simulating the future, not mimicking the past
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Calibration
Once a model structure is resolved the parameters are
adjusted so that equilibrium levels of inflation, real cash
rates, yield curve slope, corporate bond spreads, and
equity risk premiums etc are reasonable
Because of restricted data availability and changing
economic structures, estimation for some elements may
be based on a relatively short period (eg 20 years)
Is the frequency and severity of equity bear markets
reasonable compared to long run history? What is the
frequency of yield curve inversions? Do the sequences
of market returns seem plausible? Does inflation turn
negative
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Summary
Understand the features of any model structure and
whether it is appropriate for the task at hand, especially
the horizon
A model with fewer assumed linkages can be carefully
considered and is likely to be more robust than an
elaborate model
The calibration of the model is as important as structural
features and should reflect a broad perspective on
market behaviour
Does recent history of the current market environment
show enough variation (eg inflation)?
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