Lecture 11

Implementation Issues Part 2

Monte Carlo Simulation

An alternative approach to valuing embedded options is
simulation
Underlying model simulates future scenarios
Use stochastic interest rate model

Generate large number of interest rate paths

Determine cash flows along each path
Cash flows can be path dependent
Payments may depend not only on current level of interest
but also the history of interest rates

Monte Carlo Simulation (p.2)

Discount the path dependent cash flows by the
paths interest rates
Repeat present value calculation over all paths
Results of calculations form a distribution

Theoretical value is based on mean of

distribution
Average of all paths

Option-Adjusted Spread
Market value can be different from theoretical
value determined by averaging all interest rate
paths
The Option-Adjusted Spread (OAS) is the
required spread, which is added to the discount
rates, to equate simulated value and market value
Option-adjusted reflects the fact that cash
flows can be path dependent

Using Monte Carlo Simulation to

Evaluate Mortgage-Backed
Securities
Generate multiple interest rate paths
Translate the resulting interest rate into a
mortgage rate (a refinancing rate)
Include credit spreads
Add option prices if appropriate (e.g., caps)

Project prepayments
Based on difference between original mortgage rate
and refinancing rate

Using Monte Carlo Simulation to

Evaluate Mortgage-Backed
Securities (p.2)
Prepayments are also path dependent
Mortgages exposed to low refinancing rates for the first
time experience higher prepayments

Based on projected prepayments, determine

underlying cash flow
For each interest rate path, discount the resulting
cash flows
Theoretical value is the average for all interest rate
paths

Simulating Callable Bonds

As with mortgages, generate the interest rate
paths and determine the relationship to the
refunding rate
Using simulation, the rule for when to call the
bond can be very complex
Difference between current and refunding rates
Call premium (payment to bondholders if called)
Amortization of refunding costs

Simulating Callable Bonds (p.2)

Generate cash flows incorporating call rule
Discount resulting cash flows across all
interest rate paths
Average value of all paths is theoretical value
If theoretical value does not equal market
price, add OAS to discount rates to equate
values

Effective Duration
Determine interest rate sensitivity of cash flows that vary
with interest rates by increasing and decreasing the
beginning interest rate
Generate all new interest rate paths and find cash flows
along each path
Include option components

Discount cash flows for all paths

Changes in theoretical value numerically determine
effective duration

Using Simulation to Determine the

Effective Duration of Loss Reserves
Step 1
1. Determine a model for loss payments as a function
of interest rates
2. Select an interest rate model and the appropriate
parameters
3. Simulate a number of interest rate paths
4. Calculate the cash flow of loss payments for each
interest rate path
5. Discount each cash flow based on the
corresponding interest rate path
6. The economic value of the loss reserves is assumed
to be the average discounted value

Using Simulation to Determine the

Effective Duration of Loss Reserves
Step 2

1. Increase the starting short term interest rate by 100

basis points
2. Simulate a number of interest rate paths with the new
short term interest rate
3. Calculate the cash flow of loss payments for each
interest rate path
4. Discount the cash flow based on the interest rate
path corresponding with each cash flow
5. The economic value of the loss reserves if interest
rates were to change in this direction is assumed to
be the average discounted value

Using Simulation to Determine the

Effective Duration of Loss Reserves
Step 3
1. Decrease the starting short term interest rate
by 100 basis points
2. Repeat points 2-5 from Step 2
3. Use the economic values for the interest rate
increases and decreases to determine the
sensitivity of loss reserves to interest rate
changes

PV PV
ED
2 PV0 (r )

Advantages of Simulation
Type of cash flow distribution may not be clear
If one statistical distribution is used for the number
of claims and another distribution determines the
size of claims, statistical theory may not be helpful
to determine distribution of total claims
Distribution of results provides more information
than mean and variance
Can determine tails of the distribution
(e.g. 95th percentile)

Advantages of Simulation (p.2)

Mathematical estimation may not be possible
Only numerical solutions exist for some problems

Can be easier to explain to management

Possible to revise values and re-run simulation
to examine the effect of changes

Disadvantages of Simulation
Computer expertise, cost, and time
Mathematical solutions may be straight forward
However, computing time is becoming cheaper

Modeling only provides estimates of

parameters and not the true values
Pinpoint accuracy may not be necessary, though

Models are only approximately true

Simplifying assumptions are part of the model

Tools for Simulation

Spreadsheet software (Excel, Lotus)
Include many statistical, financial functions
Macros increase programming capabilities

Add-in packages for simulation

Crystal Ball or @RISK

Other computing languages

FORTRAN, Pascal, C/C++, APL

Beware of random number generators

Applications of Simulation
Usefulness is unbounded
Any stochastic variable can be modeled based
on assumed process
Interaction of variables can be captured
Complex systems do not need to be solved
analytically
Good news for insurers

Conclusion
Simulation can be a powerful tool for interest
rate modeling
Output can be extensive and impressive
Effort involved in developing a model is
generally challenging and time consuming
Usefulness of results depends on how well the
model reflects reality
Understanding the model is essential to know
when it is reliable and when it is not