Actuarial Outpost
 
Go Back   Actuarial Outpost > Actuarial Discussion Forum > Finance - Investments
FlashChat Actuarial Discussion Preliminary Exams CAS/SOA Exams Cyberchat Around the World Suggestions

DW Simpson & Co
Worldwide Actuarial

Recruitment

Entry Level Jobs
Casualty, Health,

Life, Pension,
Investment --
Insurance / Consulting

Asian Jobs
Hong Kong, China, India, Japan, Korea, Indonesia, Singapore,

Malaysia, and more

Registration Form
Be Notified of

New Actuarial Jobs


Finance - Investments Sub-forum: Non-Actuarial Personal Finance/Investing

Reply
 
Thread Tools Display Modes
  #1  
Old 04-08-2010, 06:32 PM
Mr. Wizard's Avatar
Mr. Wizard Mr. Wizard is offline
Member
SOA AAA
 
Join Date: May 2004
Location: USA
Posts: 92
Default "Real World" vs. "Risk Neutral" Scenarios

I need some educational help. Is there a good reference source, book or article out there that can help clarify when analysis should be done using "real world" scenarios (Based on historical statistical average) and "risk neutral" scenarios (Based on an arbitrage free view).

I'm trying to model how a hedging strategy would impact a block of business, and I'm confused as to whether I should model the financial impacts to the company using risk neutral or real world scenarios.

Any help or advice would be appreciated.

Reply With Quote
  #2  
Old 04-08-2010, 09:35 PM
The President's Avatar
The President The President is online now
Member
 
Join Date: Oct 2005
Location: Po'dunk USA
Posts: 14,492
Default

Here is how I would think about the two worlds:
Risk Neutral - you are going to run the block against a set of scenarios that are generated so that the replicate a set of maket prices. You really need the complete set of scenarios in order to get anything useful out of it - so you might take an average PV across all scenarios and say that this is how the market might price an insurance liability. It is all an option pricing exercise, and individual scenarios might make no sense at all - you would never expect that series of cash flows to actually materialize (at least those along the "tails").

In the real world, you are generating scenarios that you think could actually happen to get a distribution of something like GAAP earnings or some other measure. You probably won't encounter any negative interest rate scenarios in a real world scenario set, but you likely will have large negative scenarios in the risk neutral world (since it is an option pricing exercise).

For your hedging strategy, I could see you using both - you might have a nested stochastic scenario where your outer look scenarios are real world - the things you think might happen, and then at individual points along each scenario you are valuing your liabilities and assets using risk neutral scenarios that are consistent with how you would expect the market to price these options.
Reply With Quote
  #3  
Old 04-09-2010, 07:43 AM
JMO's Avatar
JMO JMO is offline
Carol Marler
 
Join Date: Sep 2001
Location: Back home again in Indiana
Studying for Nothing actuarial.
Posts: 30,437
Default

There was a session at the Investment Symposium that discusses the different way hedging flows through into Statutory, GAAP and Economic Value analysis. It may not exactly address your issue, but I thought it very interesting.
Here's a link to the handouts. (There may also be a recording available for purchase.)
http://www.soa.org/files/pdf/2010-ny-bowen.pdf
__________________
Carol Marler, FSA, MAAA, A Former Actuary
Dedicated to Retirement
Just My Opinion (Although this statement is my opinion, and I am still listed as an actuary, it's still not a statement of actuarial opinion, and you really shouldn't rely on it.)
Reply With Quote
  #4  
Old 04-09-2010, 07:57 AM
Dewey Oxburger Dewey Oxburger is offline
 
Join Date: Apr 2005
Posts: 4
Default

I found this article "When Is It Right To Use Arbitrage-Free
Scenarios?" to be very helpful.

http://www.soa.org/library/newslette...ss35-britt.pdf
Reply With Quote
  #5  
Old 04-09-2010, 09:29 AM
Mr. Wizard's Avatar
Mr. Wizard Mr. Wizard is offline
Member
SOA AAA
 
Join Date: May 2004
Location: USA
Posts: 92
Default

Thanks much for the information and the links. This is helpful.

I do have a related question. Lets assume that you are going to try and model GAAP financials using risk neutral scenarios. (Which may be a flaw according to the 9/2000 SoA article, since I can't replicate the GAAP OE cashflows solely using an investment strategy of tradeable securities.) But, if it can be done, wouldn't you need to make changes within the liability model for the analysis to be sound? For example, do you assume there is "no credit loss" deduct in a risk neutral world?

I suspect my question shows a significant level of misunderstanding on my part!

Any further advice or links to good reference information would be appreciated.

Thanks again everyone!
Reply With Quote
  #6  
Old 04-09-2010, 11:29 AM
Eimon Gnome's Avatar
Eimon Gnome Eimon Gnome is offline
Member
 
Join Date: Jun 2005
Location: Ironforge
Posts: 3,757
Default

Quote:
Originally Posted by The President View Post
Here is how I would think about the two worlds:
Risk Neutral - you are going to run the block against a set of scenarios that are generated so that the replicate a set of maket prices. You really need the complete set of scenarios in order to get anything useful out of it - so you might take an average PV across all scenarios and say that this is how the market might price an insurance liability. It is all an option pricing exercise, and individual scenarios might make no sense at all - you would never expect that series of cash flows to actually materialize (at least those along the "tails").

In the real world, you are generating scenarios that you think could actually happen to get a distribution of something like GAAP earnings or some other measure. You probably won't encounter any negative interest rate scenarios in a real world scenario set, but you likely will have large negative scenarios in the risk neutral world (since it is an option pricing exercise).

For your hedging strategy, I could see you using both - you might have a nested stochastic scenario where your outer look scenarios are real world - the things you think might happen, and then at individual points along each scenario you are valuing your liabilities and assets using risk neutral scenarios that are consistent with how you would expect the market to price these options.
Good answer.

Two items I might elaborate.

First, in the "real world", you are after distribution of results as Pres stated. What might be less clear is that there really is no point in doing present values in that world. Since the "real world" scenarios do not accurately price even a simple bond or stock, there is no information on "price" that is worth looking at.

Second, after you design your hedge in the arb free world, take a look at the the modeled results in the "real world". Most hedges require liquidity to operate (they short typically futures.) Now, if you are going to short the stock market, and lose cash each time the market goes up, there should be an obvious risk. What happens if we run out of cash? Its a good idea to frame the answer to that in the real world. How much of an opening nut do you need to keep the hedge active? How much cash could this strategy use before the liabilities all settle?
__________________
Be what you would seem to be - or, if you'd like it put more simply - never imagine yourself not to be otherwise than what it might appear to others that what you were or might have been was not otherwise than what you had been would have appeared to them to be otherwise.
- Lewis Carroll, In Philosophy
Reply With Quote
Reply

Thread Tools
Display Modes

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 10:07 PM.


Powered by vBulletin®
Copyright ©2000 - 2014, Jelsoft Enterprises Ltd.
*PLEASE NOTE: Posts are not checked for accuracy, and do not
represent the views of the Actuarial Outpost or its sponsors.
Page generated in 0.16797 seconds with 7 queries