Actuarial Outpost > Life Risk-Neutral Valuation
 User Name Remember Me? Password
 Register Blogs Wiki FAQ Calendar Search Today's Posts Mark Forums Read
 FlashChat Actuarial Discussion Preliminary Exams CAS/SOA Exams Cyberchat Around the World Suggestions

 Enter your email to subscribe to DW Simpson weekly actuarial job updates. li.signup { display: block; text-align: center; text-size: .8; padding: 0px; margin: 8px; float: left; } Entry Level Casualty Health Life Pension All Jobs

 Thread Tools Search this Thread Display Modes
#1
04-04-2017, 09:41 PM
 hothead73 Member SOA Join Date: Sep 2012 Studying for ever Favorite beer: the one I don't remember drinking Posts: 140
Risk-Neutral Valuation

Through exams and (very minimal) work exposure, I think I've come up with a working understanding of risk-neutral vs. real-world valuation methods, but I don't really understand the purpose for RN. It seems that RN scenarios should generate a best estimate price if you take the average output, and that this is (at least theoretically) equal to the average RW output. The two should be equal on average, but the tail risk is better reflected in RW scenarios and basically nonsense for RN.

So, with that said, why use RN at all? If RW scenarios give you the same answer, and can be used for forecasting, producing loss percentiles, etc., why would you prefer using RN for any purpose? Is it just a model complexity thing, where you can get to the same answer in a less computationally-intensive approach? Or is there some theoretical reason that I'm missing?
__________________
----------
#2
04-05-2017, 04:42 PM
 Numbers Nerd Member SOA AAA Join Date: Sep 2001 Location: Midwest College: University of Wisconsin Favorite beer: Ale, Lager, you name it Posts: 1,664

We use RN when looking at blocks to buy, not RW. RW is used for modeling AG43 reserves, but RN is used in Europe for reserving under Solvency II. Additionally, RN is a proxy for the amount needed to fully hedge your risk. RW is wishful thinking in my book, hoping that the future will resemble the past, despite dramatically lower interest rates.
#3
04-05-2017, 06:36 PM
 JMO Carol Marler Non-Actuary Join Date: Sep 2001 Location: Back home again in Indiana Studying for Nothing actuarial. Posts: 37,643

__________________
Carol Marler, "Just My Opinion"

Pluto is no longer a planet and I am no longer an actuary. Please take my opinions as non-actuarial.

My latest favorite quotes, updated Nov. 20, 2018.

Spoiler:
I should keep these four permanently.
Quote:
 Originally Posted by rekrap JMO is right
Quote:
 Originally Posted by campbell I agree with JMO.
Quote:
 Originally Posted by Westley And def agree w/ JMO.
Quote:
 Originally Posted by MG This. And everything else JMO wrote.
And this all purpose permanent quote:
Quote:
 Originally Posted by Dr T Non-Fan Yup, it is always someone else's fault.
MORE:
All purpose response for careers forum:
Quote:
 Originally Posted by DoctorNo Depends upon the employer and the situation.
Quote:
 Originally Posted by El Actuario Therapists should ask the right questions, not give the right answers.
Quote:
 Originally Posted by Sredni Vashtar I feel like ERM is 90% buzzwords, and that the underlying agenda is to make sure at least one of your Corporate Officers is not dumb.
#4
04-05-2017, 11:17 PM
 Celtics4Life Member SOA AAA Join Date: Jul 2011 Studying for Nothing. Favorite beer: Straight Edge Posts: 832

Quote:
 Originally Posted by Numbers Nerd RW is wishful thinking in my book, hoping that the future will resemble the past, despite dramatically lower interest rates.
Shouldn't the same answer be achieved whether you use risk neutral or real world scenarios?

In my (granted elementary) understanding of this, the differences are:

1. Risk Neutral uses risk free rates, while Real World uses risk free rates plus some parameter to reflect the market price of the uncertainty of payoff.
2. Real World uses the "true" probabilities while Risk Neutral uses "risk neutral" probabilities. These probabilities work such that one can always be derived from the other.

That being said, shouldn't the answers be the same? No matter whether you use real world or risk neutral interest rates, wouldn't you just adjust the probabilities accordingly so that the answer is the same?

C4L
__________________
ASA FSA
#5
04-06-2017, 03:48 PM
 Numbers Nerd Member SOA AAA Join Date: Sep 2001 Location: Midwest College: University of Wisconsin Favorite beer: Ale, Lager, you name it Posts: 1,664

In the context of Actuarial Guideline 43 (AG43), RW scenarios are calibrated to past performance of various indices, such as the S&P 500. They are not calibrated to market prices.
#6
04-06-2017, 05:06 PM
 jas66Kent Member SOA Join Date: May 2012 Location: London Favorite beer: Corona :) Posts: 22,626

Quote:
 Originally Posted by Celtics4Life Shouldn't the same answer be achieved whether you use risk neutral or real world scenarios? In my (granted elementary) understanding of this, the differences are: 1. Risk Neutral uses risk free rates, while Real World uses risk free rates plus some parameter to reflect the market price of the uncertainty of payoff. 2. Real World uses the "true" probabilities while Risk Neutral uses "risk neutral" probabilities. These probabilities work such that one can always be derived from the other. That being said, shouldn't the answers be the same? No matter whether you use real world or risk neutral interest rates, wouldn't you just adjust the probabilities accordingly so that the answer is the same? C4L
1. When modelling asset returns with RN there is no risk premium. So basically if you start with \$1, run 10,000 stochastic sims over the next year in regards to your asset returns, take the average of all the sims, and then discount back at the RFR, you should end up with the initial \$1 plus/minus a small standard error.

2. RW has an added risk premium which represents various calibrations of what the company (usually provided by a third party) thinks represents realistic future economic scenarios. This is usually used in P&C.
#7
04-06-2017, 05:29 PM
 Academic Actuary Member Join Date: Sep 2009 Posts: 8,567

Discounting expected values calculated using real world probabilities at risk adjusted rates gives the same value as risk neutral expected values discounted at risk free rates.

The former method underlies the CAPM which is used for primary assets and is referred to as equilibrium valuation. The latter is generally used for derivatives and is referred to as arbitrage free valuation. It is consistent with no arbitrage. The risk neutral approach facilitates valuation when the risk premia vary over time, and may depend upon the asset price.i
#8
04-06-2017, 06:08 PM
 JMO Carol Marler Non-Actuary Join Date: Sep 2001 Location: Back home again in Indiana Studying for Nothing actuarial. Posts: 37,643

Quote:
 Originally Posted by Celtics4Life That being said, shouldn't the answers be the same? No matter whether you use real world or risk neutral interest rates, wouldn't you just adjust the probabilities accordingly so that the answer is the same? C4L
Does anyone agree with this analysis?
__________________
Carol Marler, "Just My Opinion"

Pluto is no longer a planet and I am no longer an actuary. Please take my opinions as non-actuarial.

My latest favorite quotes, updated Nov. 20, 2018.

Spoiler:
I should keep these four permanently.
Quote:
 Originally Posted by rekrap JMO is right
Quote:
 Originally Posted by campbell I agree with JMO.
Quote:
 Originally Posted by Westley And def agree w/ JMO.
Quote:
 Originally Posted by MG This. And everything else JMO wrote.
And this all purpose permanent quote:
Quote:
 Originally Posted by Dr T Non-Fan Yup, it is always someone else's fault.
MORE:
All purpose response for careers forum:
Quote:
 Originally Posted by DoctorNo Depends upon the employer and the situation.
Quote:
 Originally Posted by El Actuario Therapists should ask the right questions, not give the right answers.
Quote:
 Originally Posted by Sredni Vashtar I feel like ERM is 90% buzzwords, and that the underlying agenda is to make sure at least one of your Corporate Officers is not dumb.
#9
04-06-2017, 06:10 PM
 Academic Actuary Member Join Date: Sep 2009 Posts: 8,567

Quote:
 Originally Posted by JMO Does anyone agree with this analysis?
I do. Read my previous post.
#10
04-06-2017, 06:17 PM
 jas66Kent Member SOA Join Date: May 2012 Location: London Favorite beer: Corona :) Posts: 22,626

Regulatory constraints would not allow you to value your liabilities using a heavily modified RW calibration

Also, even if you where allowed, why make your processes so onerous? Makes no sense to me.

Also, you are going to also have to tinker with the swaption implied volatilities that have been calibrated specifically for the RW model in order to deduce a fit that combines with many other variables to give you a RN output.

So once again, why do you want to make your life this hard? Makes no sense to me.

 Tags risk neutral, stochastic models

 Thread Tools Search this Thread Search this Thread: Advanced Search Display Modes Linear Mode

 Posting Rules You may not post new threads You may not post replies You may not post attachments You may not edit your posts BB code is On Smilies are On [IMG] code is On HTML code is Off

All times are GMT -4. The time now is 07:48 AM.

 -- Default Style - Fluid Width ---- Default Style - Fixed Width ---- Old Default Style ---- Easy on the eyes ---- Smooth Darkness ---- Chestnut ---- Apple-ish Style ---- If Apples were blue ---- If Apples were green ---- If Apples were purple ---- Halloween 2007 ---- B&W ---- Halloween ---- AO Christmas Theme ---- Turkey Day Theme ---- AO 2007 beta ---- 4th Of July Contact Us - Actuarial Outpost - Archive - Privacy Statement - Top