Chapter 18: modelling

Question 1

Operational issues that need to be considered to be included in a model

Answer 1

be well documented
be easily communicable, with clearly displayed results
have sensible joint behaviour of variables
be capable of independent verification
not be overly complex or time-consuming to run
be capable of development and refinement
be capable of being implemented in a range of ways
have an appropriate time period between projected cashflows, balancing the reliability of the output with the speed of running the model.

Question 2

Steps to develop a deterministic model

Answer 2

specify the purpose of the investigation collect, group and modify data
choose the form of the model, identifying its parameters or variables
ascribe values to the parameters using past experience and appropriate estimation techniques
construct a model based on the expected cashflows test the model in order to identify any build errors, and correct if necessary
check that the goodness of fit is acceptable (and attempt to fit a different model if the first choice does not fit well)
run the model using estimates of the values of variables in the future
run the model several times to assess the sensitivity of the results to different parameter values.

Question 3

Steps to develop a stochastic model

Answer 3

Same process as a deterministic model but with the following additional steps:
choose a suitable density function for each of the variables to be modelled stochastically specify correlation between variables
run the model many times, each time using a random sample from the chosen density function(s)
produce a summary of the results that shows the distribution of the modelled results after many simulations have been run, e.g. at various confidence levels.