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6/10/15

Business School

ACTL4303 AND ACTL5303


ASSET LIABILITY MANAGEMENT

Week 10
Asset Liability Models

Stochastic Asset and Liability Models


Dynamic Financial Analysis (DFA) applies financial models to
analyse pricing, reserving, and capital adequacy in insurance
(and similar issues in superannuation)
Three basic components
1. Economic Scenario Generator (ESG)
2. Liability Projection Model (usually dependent on bond
yields and inflation from ESG)
3. Decision Making Model (analysis of key variables)

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Economic Scenario Generators (1)


Simulate the economic and financial environment globally
including for example:

Long term interest rates


Short term interest rates
Stock market returns
Real estate returns
Inflation (consumer, medical, wages)
Exchange rates

The objective of an ESG is not prediction or asset pricing


It is to enable probabilistic conclusions by simulating a
realistic distribution of outcomes
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Economic Scenario Generators (2)


Common design variants are:
Cascade models. Variables depend only on lagged values of
themselves and variables of higher order, usually incorporating some
form of longer term mean reversion to equilibrium.
Efficient market models. Often derived from stochastic differential
equations involving Weiner processes (time independent).
Vector Auto-Regressive Models. These are non-prescriptive about the
structure of relationships and contemplate a complex web of
autoregressive relationships, prone to unstable estimation

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Economic Scenario Generators (3)


In evaluating an ESG, consider:
What is the purpose? (eg Long-term strategy assessment or short-term
solvency tests)
Critically, evaluate the theory and thinking behind the model structure
Is the model calibrated on a relevant dataset (eg inflation since inflation
targeting monetary policy regime)?
How does the model contemplate extreme equity behavior?
Are the linkages between asset classes and inflation reasonable and
practical?
Is the model hostage to theory and in contradiction of data or vice versa?

The Wilkie Model ( a cascade example)

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The Wilkie Model (1986, 1995)


This is the original actuarial ESG
While widely criticised, Wilkie made the model development
public, provoking much constructive discussion and
examination
The focus of this model was originally on the maturity
guarantees offered by life insurance offices (very long term)
It was not intended, and arguably inappropriate, for shortterm applications involving tail probabilities

The Wilkie Model (1986, 1995)


Assumes a single inflation regime
Dividend yield depends on prior values and inflation
Dividend growth depends on current and past inflation, past dividend
yield shocks and a moving average of past values
Share prices derive from dividend growth and dividend yield
The equity structure contradicts a random walk of stock prices
Long term interest rates have an inflation component (exponentially
weighted moving average) and an inflation-adjusted yield
Short-term interest rates modeled as a spread from long-term rates

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Model Evolution post Wilkie

Frank Russell Stochastic Programming Models (1991)


CAP:Link was an early Towers Perrin ESG (1996,2006)
Aon Consulting Model 1999
Casualty Actuarial Society (CAS) and the Society of
Actuaries (SOA) made a model publicly available in 2005
American Academy of Actuaries (AAA) also supplies
scenarios for testing capital adequacy, particularly where
variables annuities are involved
Following the merger between Towers Perrin and Watson
Wyatt CAP:Link is now defunct
Towers Watsons current model is Star ESG (2008)

CAP:Link Economic Scenario Generator Cascade structure (1996)

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CAP:Link subsequent evolution (2006)


Short and Long Interest Rates and Full Government Yield Curve

Real GDP
Price Inflation
Earnings Yield

Earnings Growth

Currency Strength

Credit Spreads

Note emphasis on yield curve, incorporation of GDP, inflation shift


to lower in the cascade and change from dividends to earnings to
model equity returns
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Towers Watson Star ESG (2008)


Nominal interest rates
The Norman (2009) Real World Extension of the Libor
Market Model. This model is also used, with minor
adjustments, to model real yields and LIBOR spreads
Inflation
Linear function of current and past short-term interest rates
and inflation
Error term is AR(1) with conditional heteroskedasticity to
give higher volatility in higher inflation environments
Equity returns
Geometric Brownian motion with jumps
Linkage via Students T Copula to address tail correlations
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Towers Watson Star ESG CAP:Link successor

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Towers Watson Star ESG


Inflation influenced by monetary policy

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Towers Watson Star ESG


Equity Returns no longer dividends or earnings

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Inflation modelling (1)


The CAS-SOA (2005) model is similar to Wilkie (1986)

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

Is the real-world inflation process stationary?


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Inflation modelling (2)


The Star ESG (2008) recognises that the volatility of
inflation is autoregressive and dependent on the level of
inflation. Inflation is related to its prior value, the level of
short-term interest rates and the recent change in interest
rates:

= q + r t + (r t r t1) + + e t

t1

e = pe
t

where r

t1

2
t1

is the short-term interest rate


e t is the error term
t is a normal random variate
Monetary policy drives inflation in this model, consistent
with the Taylor rule
t

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Equity return modelling (1)


Early long-term ESG models (eg Wilkie, CAP-Link)
separately projected equity income (earnings or dividends),
and the multiple applied to that income (dividend yield or
earnings yield)
As the focus of ESGs shifted to the short term, there was
more attention to modelling extreme market behaviour
Regime switching models are a simple and effective way of
mixing distributions for different market environments
They accord with the traditional perspective that bear
markets have different return and risk characteristics

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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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Equity return modelling (2)


The CAS-SOA model uses a two regime log-normal model
structure with different parameters for large and small
stocks
Regime switches for large and small stocks are correlated
(natural extension for global equities)
Correlation of regime states (markets being in bear markets
at the same time) will mimic the tendency for correlations to
increase when markets are weak
Another way of allowing for extreme volatility is a jump
model (Star-ESG)

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Inflation and asset returns


Assumed relationships between inflation and asset returns need to be
carefully scrutinised
An invalid relationship may still find empirical support because of
peculiarities of the period over which the model is calibrated
In a small open economy currency fluctuations, and policy response,
add to the complexity of relationships
If an asset liability model incorporates a positive relationship between
inflation and risky assets this will justify higher weightings to risky
assets
The reliability of any such assumption needs to be well understood

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Inflation and bond yields


Bond yields price inflation expectations over the term of the bond
If inflation targeting is credible, variations in short-term inflation will
affect the slope, moreso than level, of the yield curve (Taylor Rule,
Nelson-Siegel)
Estimation of bond yield relationships is conditional on the monetary
policy regime, and its perceived effectiveness
A supply-side shock (eg energy or food prices) might shake confidence
in inflation targeting

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Inflation and equity returns


In a low inflation regime the equity market will be relatively insensitive
to modest fluctuations in the inflation rate
In the transition to a high inflation regime bond yields will move higher
and this may devalue equities, though not necessarily
If a high inflation regime is due to cost-push inflation, profit margins will
compress and equity returns may suffer
If a high inflation regime is driven by a positive output gap (demand
pull), profit margins may expand and equity returns may benefit
There is no clear connection between the inflation environment and
equity returns in the short term
If inflation is due to currency weakness the relationship is more
nuanced

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Currency and equity returns


A weaker currency will increase the price of imported goods but the
impact on consumer prices may be subdued and gradual
The currency may be weak due to inferior terms of trade and
consequent weak demand
A weaker currency assists exporters and import competing companies
Higher inflation arising from more expensive tradables may therefore
coincide with improved equity returns as domestic financial conditions
ease
A weaker currency also improves the returns from unhedged overseas
equity investment

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Model risk and parameter risk


Model risk arises from the model being an approximation to a complex
economic system
Parameter risk arises from treating estimated parameters as the actual
parameter values
Given model risk and parameter risk the uncertainty of outcomes is
potentially wider than suggested by a model
I know my model is probably incomplete, and even if it is appropriate,
the parameter estimation is inaccurate. The future may surprise relative
to simulated distribution.

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Asset liability model simplification


We can imagine a labyrinth of relationships moving beyond inflation
and asset returns and encompassing a wide range of multi-country
dynamics including policy response scenarios and economic shocks.
Very quickly the complexity of an imaginative model will overwhelm the
statistical significance of estimation
There will also be questions about how the future may be structurally
different to the data span of estimation
Understanding the inevitable shortcomings and inherent biases of an
asset liability model is as important as the design of the model

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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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