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**Mathematics of Gambling and Investment: Scenarios 2
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Some mathematical approaches for scenario generation and reduction

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cenarios represent the set of possible future outcomes of the random parameters of the model at hand over the decision horizon. Since the number of scenarios can be very large, procedures to reduce their number while still retaining their representation of the future are of interest. So are ways to generate scenarios from given distributions. In this second of three columns, I discuss two basic mathematical approaches to accomplish this. The third column will discuss how economic models, especially those relating to interest rates, earnings and other key economic variables can be used to generate scenarios that tilt the past towards more likely futures. The first way is that scenarios can be generated by moment matching. The idea is that the reduced set of scenarios has the same moments as the original larger set of scenarios to some order. We used this idea in the five period Russell-Yasuda Kasai insurance model in 1989 which is discussed in Cario, Myers and Ziemba (1998). Smith (1993), Keefer and Bodily (1993), Keefer (1994) have suggested such methods for static problems. Hyland and Wallace (HW) (2001) have expanded and refined the idea for multiperiod problems and they generate scenarios that match some moments of the true distribution. Typically it is the first four moments. Extension of the HW work are in Hyland, Kaut and Wallace (2001) and Kouwenberg (1999).

The procedure is easy to use and provides adequate scenarios. It does have its faults because the two distributions in Figure 1 have the same first four moments.1 Such mathematical mismatches aside, the HW approach is to find a set of discrete scenarios that best fits the distributions first four moments minimizing least squares. The scenario tree consists of realizations and their probabilities of all random parameters in all time periods. The optimization problem is min w i ( fi ( s, p ) − Q i ) 2

x ,p i∈ Q

**Figure 1: Four moments
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0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -5

λM = 1 λ≥0

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Wilmott magazine

38 15.80 0.10 -0.60 -0.30 1 Intern’l Stocks -0.16 Cash Cash 1 Bonds Domestic stocks International stocks Bonds Domestic Stocks 0. with weight wi .Cash Bonds Domestic stocks International stocks.96 -25. standard deviation and correlation data in these tables is shown in Figure 3 Figure 2: Fitted cumulative distribution functions and the derived density functions for the asset classes Wilmott magazine 13 ^ . M is a matrix of zeros and ones.cash. The correlations are shown at the top right of this page. whose number of rows equals the length of λ and whose number of columns equals the number of nodes in the scenario tree. consider four asset classes . HW’s examples.91 7. The aim is to construct the return r and the probabilty p so that the statistical properties match those of the specified distribution. A kurtosis of less than three means that the distribution is less peaked around the mean than the normal distribution. single and multiple period.60 1 where Q is the set of all specified statistical properties and Qi the value of i ∈ Q .84 -31. however. does not guarantee that the second derivative does not change sign.97 Worst-case event (%) 6.20 0. Once these are estimated the scenarios can be generated.33 5.93 2. Figure 2 shows fitted cumulative distribution functions for the four asset classes and their corresponding derived density functions (some with odd shapes) where the specified percentiles are denoted by triangles.62 2.94 0. The normal distribution has a kurtosis of three. domestic stocks and international stocks and the expectations are in terms of the interest rate for cash and bonds and total returns for stocks.49 -0.75 -0. This is a preferred way to solicit expert’s future views of key model parameters. A set of six scenarios that exactly match the expected return. HW use the NAG C library routine which.70 Skewness 0.39 2.61 8. Expected value (%) 4. Various methods exist for eliciting these distributions.68 7. The decision maker must specify their (subjective) expectations for the marginal distributions. Each column in M provides a conditional distribution at a node in the scenario tree. The properties of the marginal distributions in the HW example are shown at the top left of this page.82 13.74 Kurtosis 2. bonds.09 Standard deviation (%) 0.20 1 -0. For calculations.

and interest rates tend to fall and when interest rates are low.84% 8.74 2.t−1 + (1 − ci )σAit where ci ∈ [0.74 2.309 5.80 2. Correlations are as in period one for all three periods. Other factors are assumed to be state independent and equal to the specifications in period 1.97 -31. 2.190 where the worst case event is given in the left most scenario.t−1 Asset class Cash-duration three months Bonds-duration six years Domestic stocks International stocks Distribution property expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event (end of) Period 1 4. but not after a large increase.82% 0.573 12.75 2.75 2. starting with Fischer Black in the 1970s show that the volatility for stocks increases after a large decrease in stock prices.68% 5. Mean reversion means that interest rates tend to revert to an average level.t = MRF i MRL i + (1 − MRF i )ri.33% 0.93 State dep State dep State dep -0. respectively. Modeling this asymmetry is straightforward. For period 1..74 2. HW assume that the volatility for asset class i t > 1 is in period ¯ σit = ci ri. the mean reversion factor MRF i = 0.38% -0. Empirical studies.09% 15. starting with Fischer Black in the 1970s show that the volatility for stocks increases after a large decrease in stock prices.61% 13.49 2.62 State dep State dep State dep 0.62 State dep State dep State dep 0. These market expectations are summarized to the left.96% 7.49 2.39 State dep State dep State dep -0. For stock. For example.t−1 − ri. ri.92 42.2 for all interest rate classes and the mean reversion level MRL i = 4% and 5.97 State dep (end of) Period 3 State dep State dep 0. Multiperiod scenario trees must either have independence across time or more likely have an intertemporal dependence structure. The assumption is that when interest rates are high. the economy slows down.t the interest rate for bond class i in period t.3 for all assets. 1] is the mean reversion factor (the higher the more mean reversion).t is the real¯ ized return with expectation ri. These include volatility clumping and mean reversion. σit is the standard deviation and RPt is a risk premium constant for period t. The volatility clumping parameter ci = 0.t and σAit is the average standard deviation of asset i in period t. MRL i is the mean reversion level and ri.3 for t − 1.75 2.509 30.t = rft + RPt σit where rft is the risk-free interest rate. They model mean reversion of the two bond ¯ classes using ri.16% (end of) Period 2 State dep State dep 0. but not after a large increase where MRF i ∈ [0. Wilmott magazine 8. The risk premium RPt = 0.93 State dep State dep State dep -0. the assumptions are as in figure 3. but to simplify the presentation. 1] is a volatility clumping parameter (the higher the more clumping).39 7. HW assume equal volatility dependencies for all asset classes.8% for cash and bonds. For periods 2 and 3. Moving from static one-period scenarios to dynamic multiperiod scenarios has several added complexities such as intertemporal dependencies that need to be considered.93 -25.91% 0.BILL ZIEMBA Figure 3: Six scenarios that match the expected return. HW assume that there is a premium in terms of higher expected return which has associated with it more risk. 3.62 6.80 2.70% -0. The expected return ¯ is then ri. standard deviation and correlation data of the HW example Interest rate / total return 20 10 0 -10 -20 -30 -40 0.80 2.49 2.97 State dep 14 . the expected values and standard deviations are state dependent as modeled here.39 State dep State dep State dep -0.5 cash bonds dom stocks int stocks Empirical studies. the economy improves and interest rates rise.94% 0.

063 -0. An example is the t-distribution with two degrees of freedom with density (2 + x2 )−3/2 .064 0.259 0.226 0.01 0.087 -0.231 0.066 0.058 0. Hence they propose this alternative approach which approximates distributions with very few scenarios.415 0.07 0.094 0.081 0.093 0.024 0.043 0. Moment matching can yield strange distributions.067 0.148 0. the approach does not control the statistical properties over all realizations in periods t = 2.2 0.035 0.293 0.3 0.028 0.07 0.087 0.36 -0.26 -0.051 -0.014 -0.06 0.214 0.063 0. . due to Hochreiter and Pflug (HP) (2002).079 0.049 0.422 0.085 0.21 0.037 0. This sequential approach requires the distribution properties to be specified at each node in the tree.066 0.005 0.105 -0.26 -0.29 prob cash bonds dom stocks int stocks 0.058 0. Hyland and Wallace use a sequential procedure: (1) specify statistical properties for the first period and generate first-period outcomes. usually ensures that a perfect match is obtained for each of the generated single-period trees if one exists.14 0.236 0.091 0.101 0.076 -0. Continue specifying conditional distributions to generate consistent outcomes in all periods.506 0.043 0.067 -0.146 -0.046 0.492 0.123 0.166 0.095 0.36 0.044 0.359 0.0.048 0.288 0.417 0.005 0. Figure 4: Approximation of a t-distribution with a Kolmogorov-Smirnov distance on the left and the Wasserstein distance measure on the right Wilmott magazine 15 ^ .042 0.058 0.182 0.174 0.225 0.031 0.073 -0.119 0.038 0.092 0.359 0.048 0.064 0. The drawback is a much more difficult optimization problem.04 0.021 -0.099 0.059 0.225 0.056 -0.043 0.049 0.082 -0.05 -0.115 0.034 0. See Hyland and Wallace (2001b) and Hyland.332 0.035 0. A three-period scenario tree that has a perfect match with these specifications was generated in 63 seconds on a Sun Ultra Sparc 1 (each single period tree takes less than a second to construct).31 0.077 0.037 0.234 0. The Kolmogorov-Smirnov (KS) distance approximations is an alternative approach but it does not take care of tails and higher moments.023 0.051 0. generates scenario trees using a multidimensional facility location problem that minimizes a Wasserstein distance measure from the true distribution.22 -0.08 -0.084 0.045 -0.22 0.005 0.005 0.046 -0.02 0.372 0.047 0.25 -0.26 -0. Knut and Wallace (2001) for more discussion.07 -0.306 0.07 -0.059 0.163 0.401 0.18 There are alternative ways of constructing the multiperiod trees.19 0.069 0.027 0.105 -0. . the location of the minimum is closer to the true value and the 0.025 0.238 0.222 0. The first two scenarios which have a perfect match are shown at the top left of this page.12 0.072 0.063 0.03 0.337 0.049 0.18 -0.163 0.05 0.15 -0.33 0.068 0.01 0.059 0.36 -0.31 0. specify conditional distribution properties for the second period and generate conditional second-period outcomes. This approach has numerical advantages from the decompositon into single-period trees.067 0.035 0.005 0.259 0.07 -0.058 0.28 0.095 -0.293 0.128 -0.044 0.197 0. An alternative is to construct the entire tree in one large optimization.31 0. The latter gives better approximations.062 -0.061 0.035 0.1 -0.046 -0.45 0.041 -0.22 0.08 -0.08 -0.26 0.042 0.057 0.02 0.083 0.37 0.023 0.096 0.052 0.067 0.067 0.073 0. Hence.21 0.061 0.066 0.. This density is approximated in Figure 4 with the KS distance on the left and the Wasserstein distance on the right. 3.25 -0.055 0.119 0.08 -0.074 0.262 0.09 0.053 0. .198 -0.263 0.44 0.095 0.03 0.052 0.182 The HP method combines a good approximation of the moments and the tails This approach will render infeasible one period subtrees that lead to conditional multiperiod trees that do not have a full match.005 0.059 0..065 0.089 0. However. Each single-period optimization problem is nonconvex. by adjusting the number of outcomes and reoptimizing from alternative starting points.036 0.394 -0.078 -0.082 0.48 -0.079 0. The second approach. (2) for each generated first-period outcome.062 0. The HP method combines a good approximation of the moments and the tails.062 0.23 0.05 -0. HW found also that stability (the same objective value for different scenario trees) is improved by solving for larger scenario trees by aggregating several smaller scenario trees.054 0.064 0.

.494) 1.498) 1. .978 (0.03 and bonds with probabilities 0.012 (0.997 (0.04 (0.519) 1. The bond-stock correlation is –0.524) 1.054 (0. .506) 1.2146 0 1.494) 1. .26.032 (0.998 (0.047 (0.497) 1.055 1.5) 1.511) 1.2637) 1. earnings.499) 1. m Figure 5: Scenario generation procedure Set up periods and stages Simulate outcomes for both asset classes Generate scenario tree for asset class Stocks Generate scenario tree for asset class Bonds Generate product tree with scenario reduction Scenario Tree The Wasserstein distance is the solution of the non-convex program min min |u − cj | dG(u) : c1 . .23 0.503) 1.0305 (0.29 which return 1.0425 (0.487) Figure 7: Scenario simulation 16 Wilmott magazine .959 (0.035 (0.476) 1. An example follows 1.041 (0. pi = 1 .045 (0.52 0. The optimal approximation of a continuous distribution G by a distribution with mass points z1 . .368) 1.0854 0.489) 0.0435 (0.19 1.512) 0.489) 1.918 (0. .965 (0.BILL ZIEMBA mean is closer as well.055 0. The KS distance is invariant with respect to monotone transformations of the x-axis and thus does not approximate the tails well like the Wasserstein distance.5) 1.05 0.052 (0.53) 1. zm with probabilities p1 . Observe how few scenarios are used for the approximations.92 for stocks which return with probabilities 0.0345 (0.506) 0. especially those with interest rates.052 (0. towards more likely future scenarios.049 (0. .0435 (0.032 (0.981 (0. Figure 6: Scenario tree for stocks and bonds Scenario tree (stocks) Scenario tree (bonds) 1. .991 (0.19 1.0365 (0.04 0 0. .501) 1.488) 0.51) 1.972 (0.507) 0. .933 (0.954 (0.2842) 1. .532) 1. based on past data. pm using the KS distance is zi = G−1 2i − 1 2m .22 0.488) 1.041 (0. .468) The locations c1 .05 0.506) 1. .08 (0.92 1.3054 0.03 0.0154 0. cm then yield the probabilities pi = dG(u). .47) 0.4 so the joint probability matrix is 1.479) 1. In the third scenario column I will discuss how various economic models.2046 0 0. {u :|u − ci |=min |u − cj |} 0.021 (0.039 (0.000 (0.0505 (0.502) 1.512) 1. .048 (0. cm ∈ R . Figure 5 shows the scenario generation procedure. etc involved and expert judgment can be used to tilt existing scenarios.481) 0.3223) 1.1746 1.049 (0.0405 (0.4521) This yields the scenario trees in Figure 6 and 8 and the scenario simulation in Figure 7.48 0.057 (0.039 (0.038 (0.521) 1.49) 1.042 (0.3097) 0.04 1.513) 1.502) 0.

W 17 Wilmott magazine .0956) 1. technical issues and uses of the Russell-Yasuda Kasai financial planning model.954/1.972/1.035 (0.052/1.5327) 0. Management Science 40.505 (0.. R.047 (0.045 (0. W. Ziemba (1998).506) 1.049/1. A heuristic for generating scenario trees for multistage decision problems.032/1.0505 (0.1974) 1.933/1. Management Science 29.959/1. Bodily (1983).039 (0. E [x 3 ] = E [y 3 ] = 0 and E[x4 ] = E[y4 ] = 9/5.0365 (0. T. s Keefer.4772) 1.049/1.0345 (0.978/1.972/1. Concepts.038 (0.041/1.5241) 0.5262) 1. K.978/1.471) 0.5198) REFERENCES s Cario.054 (0. Kaut.4937) 1.039 (0.4673) 0. 595—609. and S.0305 (0.959/1. 340—358. D. and S.5063) 1.057/1.965/1.08/1.997/1.4902) 0.0889) 0.045 (0. Myers.529) 1. Scenario generation and stochastic programming models for asset liability management.052 (0. 1 X is uniform on [− 3. Stochastic programming e-print series. European Journal of OR.032 (0.5201) 0. √ √ 3]. s Hyland.5159) 1.5278) 1. Moment methods for decision analysis.4010) 1. J.998/1. Management Science 47. s Hochreiter and Pflug (2002).0435 (0. and 3Z 5 Y= 3I 5 1/4 + 1− where I is -1 or +1 with probability 0.0345 (0.012/1. Hochreiter and Pflug (2002) derived this example using ideas from Heyde (1963) who showed that even infinite moment matching would not replicate all distributions.08/1. Then E [x ] = E [y ] = 0 .032/1.4759) 0.041 (0. s Kouwenberg. (1999).035 (0.041/1.049/1.918/1.042 (0.038 (0.918/1. D.981/1.054 (0.4722) 1. s Keefer.5228) 0.0405 (0.4705) 1.057/1. E [x 2 ] = E [y 2 ] = 1 .009/1. W. Wallace (2001).04 (0.049/1.965/1.4841) 1.Figure 8: Combined scenario tree for stocks and bonds Combined scenario tree (stocks and bonds) 1.4799) 0.494) 1.954/1. L.0435 (0. Operations Research 46. M.021/1.5098) 0. and S. E.5209) 0.5295) 0. E.052 (0.048 (0.4784) 1. 450—462. 760—773.0435 (0. Generating scenario tress for multistage decision problems. s Hyland. s Heyde (1963).032 (0. L.4802) 0.052/1. . Three-point approximations for continuous random variables. Management Science 39.4791) 0. Wallace (2001). 1).0365 (0.039 (0.5 and Z is N (0. (1993).047 (0. K.0305 (0. 295—307.038 (0. Certainty equivalents for three-point discrete-distribution approximations.5216) 1.041/1.2171) 0. R. s Smith.471) 0.933/1. and W.048 (0. D. (1994).

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