Chapter 18: Modelling Flashcards
Requirements of a good model
A good model will:
- be valid, rigorous and well documented
- be communicable and the output verifiable
- 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.
- reflect the risk profile of the business being modelled
- allow for all the significant features of the business
being modelled
- have appropriate input parameters and parameter values
A model needs to allow for all the cashflows that may arise, including:
- guaranteed and discretionary benefits e.g.
reversionary and terminal bonuses
- cashflows arising from any supervisory requirement to
hold provisions
- the potential cashflows arising from options and
guarantees
Dynamic model
Allows for the interaction between the parameters and variables affecting the cashflows
Steps involved in running a deterministic model
- specify the purpose
- collect, group and modify the data
- choose the form of model
- identify the parameters and variables
- ascribe the parameter values
- construct a model based on expected cashflows
- check the goodness of fit is acceptable
- fit a new model if the first choice does not fit well
- run the model using selected values of the variables and values that will apply in the future
- sensitivity test the parameters
Steps involved in running a stochastic model
- specify the purpose
- collect, group and modify the data
- choose a suitable density function for each stochastic variable
- specify the correlations between the variables
- construct a model based on expected cashflows
- check the goodness of fit is acceptable
- fit a new model if the first choice does not fit well
- run the model many times using randomly generated values of the stochastic variables
- produce a summary of the results
Risk discount rate could allow for
- the return required by the company
- the level of statistical risk (assessed analytically or by sensitivity analysis or from a stochastic model)
Premiums resulting from the model may need to be considered relative to the market, which may require reconsideration of:
- product design
- distribution channels
- profit requirement
- size of the market
- whether to go ahead with the product
Define a model
A cut-down, simplified version of reality
…. that captures the essential features of a problem
…. and aids in:
—- understanding of the problem.
—- producing (potential) answers to the problem.
3 Approaches to obtaining a model
- a commercial modelling product could be purchased
- an existing model could be reused, possibly after modification
- a new model could be developed
The merits of the modelling approaches will depend on (5)
- the level of accuracy required
- the “in-house” expertise available
- the number of times the model is to be used
- the desired flexibility of the model
- the cost of each option
The prime objective in building a model
To enable a provider of financial products to be run in a sound financial way.
Merits of a deterministic model
- more readily explicable to a non-technical audience, since the concept of variables as probability distributions is not easy to understand.
- it is clearer what economic scenarios have been tested
- the model is usually easier to design and quicker to run.
Disadvantage of a deterministic model
it requires thought as to the range of economic scenarios that should be tested.
Merits of a stochastic model. what are stochastic models particularly good at?
Tests a wider range of economic scenarios.
Stochastic models are particularly important in assessing the impact of financial guarantees.
Disadvantage of a stochastic model
The programming is more complex and the run time longer.
What is meant by a “dynamic” model
The asset and liability parts are programmed to interact as they do in reality
and the assumptions affecting assets and liabilities (for example inflation and interest rates) are consistent.
