Actuarial Notes

Economic Scenario Generators: A Practical Guide

By Hal Pedersen, Mary Pat Campbell, Stephan L. Christiansen, Samuel H. Cox, Daniel Finn, Ken Griffin, Nigel Hooker, Matthew Lightwood, Stephen M. Sonlin and Chris Suchar · Society of Actuaries · 2016

Study guide: Exam CP-312

An in-depth primer on economic scenario generators (ESGs), published by the Society of Actuaries in July 2016. An ESG is a software tool that simulates future paths of economies and financial markets. The first half of the guide covers what ESGs are, how they evolved, how they meet regulatory and business needs in the insurance and pension industries, and what makes a good one, with guidance on model specification, calibration and validation; the second half gives the technical treatment of arbitrage-free modeling, risk-neutral scenarios, interest rate, corporate bond and equity index models, and international considerations.

On the syllabus

  • Exam CP-312 — Chapters 1, 2, 4.1-4.3, 5, 6, 7.1-7.3 and 8, for outcomes 2a and 2b (Topic 2).

Introduction

Executive Summary

1 What Is an Economic Scenario Generator?

  • 1.1 Overview of ESG Models
  • 1.2 ESG Model Components
  • 1.3 Relationships Between Model Components
  • 1.4 Structural ESG Model Components
  • 1.5 Chapter Summary
  • 1.6 Chapter References

2 The Need for Economic Scenario Generators

  • 2.1 Simulation versus Analytical Solutions
  • 2.2 Analytics and Simulation: An Illustration
  • 2.3 Historical Context: The Big Bang and Emergence of ESGs
  • 2.4 ESG Model Applications
  • 2.5 How ESGs Differ from Other Economic Models
  • 2.6 Limitations of ESG Approaches
  • 2.7 Chapter Summary
  • 2.8 Chapter References

3 The Role of ESGs in Satisfying Regulatory Requirements

  • 3.1 Applications of ESGs in Responding to Evolving Regulatory Requirements
  • 3.2 Specific Regulatory Requirements with Respect to ESGs
  • 3.3 General Regulatory ESG Considerations
  • 3.4 Chapter Summary
  • 3.5 Chapter References

4 Business Applications of ESGs in the Insurance and Pension Industries

  • 4.1 Life Insurance Applications
  • 4.2 Pension and Retirement Applications
  • 4.3 Property and Casualty (P&C) Applications
  • 4.4 Chapter Summary

5 What Are the Essential Features of a Good ESG?

  • 5.1 Real World versus Market Consistent
  • 5.2 Essential Features of a Good ESG
  • 5.3 Advanced ESG Attributes
  • 5.4 How Good Is an ESG, Really?
  • 5.5 Chapter Summary
  • 5.6 Chapter References

6 Considerations of Model Specification and Stylized Facts

  • 6.1 Stylized Facts
  • 6.2 Considerations in the Determination of Stylized Facts
  • 6.3 Overview of Commonly Modeled Economic and Financial Variables
  • 6.4 Overview of the Equity Markets
  • 6.5 Chapter Summary
  • 6.6 Appendix: Data Sources
  • 6.7 Chapter References

7 Model Calibration and Parameterization

  • 7.1 The Calibration Process
  • 7.2 Calibrations of Market-Consistent ESG Models
  • 7.3 Parameterization (calibration) of Real-World ESG Models
  • 7.4 Methods of Parameterizing Real-World ESGs
  • 7.5 Chapter Summary
  • 7.6 Chapter References

8 Model Validation

  • 8.1 General Considerations in Developing a Validation System
  • 8.2 Specific Considerations in Validation of Real-World ESGs
  • 8.3 Validation of Market-Consistent ESGs
  • 8.4 Validation: Final Thoughts
  • 8.5 Chapter Summary
  • 8.6 Chapter References

9 Arbitrage-Free Modeling Considerations

  • 9.1 Arbitrage-Free Financial Models
  • 9.2 Applying a Practical Application
  • 9.3 Is the Arbitrage-Free Framework Necessary?
  • 9.4 Martingale Tests
  • 9.5 Chapter Summary
  • 9.6 Chapter References

10 The Role of Risk-Neutral Scenarios

  • 10.1 What Does “Risk-Neutral” Mean?
  • 10.2 Applications of Martingale Tests in Practice
  • 10.3 What Is the Purpose of Risk-Neutral Scenarios?
  • 10.4 Deciding Between Real-World and Risk-Neutral Scenarios
  • 10.5 When Are Real-World and Risk-Neutral Scenarios Used Together?
  • 10.6 Chapter Summary
  • 10.7 Chapter References

11 Default-Free Interest Rate Models

  • 11.1 Important Properties of Robust Interest Rate Models
  • 11.2 Binomial Interest Rate Models
  • 11.3 Continuous-Time Single-Factor Models of the Term Structure
  • 11.4 More Advanced Models for the Term Structure
  • 11.5 Chapter References
  • 11.6 Appendix: Mathematical Details for a General Single-Factor Model

12 Corporate Bond Models

  • 12.1 Definition and Key Considerations of the Corporate Bond Market
  • 12.2 The Mechanisms of Corporate Bond Modeling
  • 12.3 Structural/Merton Models
  • 12.4 Reduced-Form Models
  • 12.5 Ratings-Based Models
  • 12.6 Other Issues
  • 12.7 Chapter References

13 Equity Index Models

  • 13.1 General Consideration of Equity Models
  • 13.2 The Standard Black-Scholes Model
  • 13.3 The Heston Model
  • 13.4 The Stochastic Volatility with Jumps (SVJ) Model
  • 13.5 Regime-Switching Model
  • 13.6 Econometric Models
  • 13.7 Chapter References

14 International Considerations

  • 14.1 Single-Economy versus Multi-Economy Modeling
  • 14.2 Details of Similar Asset Classes Can Vary Significantly Across Economies
  • 14.3 Data Issues in Modeling Global Economies
  • 14.4 The Importance of Co-Movements Between Economies
  • 14.5 Foreign Exchange (FX)
  • 14.6 Constructing Global Economies from Single-Economy Models
  • 14.7 Chapter References

Annotated Bibliography

  • Interest Rates
  • Corporate Bonds and Credit Ratings
  • Stock Price Models
  • Investment Models, Economic Scenario Generators

Glossary

Sources