Capital Market Simulation
See also Capital Market Simulation under Output.
Forecast valuations are based on future economic and actuarial assumptions. These assumptions can include inflation, actuarial assumptions tied to interest rates and investment returns. The user must specify each of these assumptions for each year of the forecast.
In a deterministic forecast, the user specifies each of these assumptions precisely for each year of the forecast. Example:
Inflation is A% per year
Accounting discount rate(s) and U.S. PPA segment rates remain at their current levels
Investment returns are B% for a first simulation year of 2010 and C% per year thereafter
This assumption set defines a single path through time, typically referred to as a single trial.
By contrast, a stochastic forecast runs a number of trials (often, 2,000 or more), where the trials are designed to 1) reasonably span the universe of possible outcomes for each variable and 2) obey a set of overall governing properties and inter-relationships. An example of overall properties is that, for the simulation period, the nominal annual returns for Canadian Large Cap equities follow a distribution that has an expected value of 8.0% and a standard deviation of 18.0%. An example of the inter-relationships would be the coordination of interest rates and bond returns, where the user can specify how much of the nominal return for Core Fixed Income is attributable to changes in modeled interest rates and how much is attributable to factors other than interest rates.
A Capital Market Simulation is the matrix of data that defines the (thousands of) trials defining and coordinating the values for inflation, interest rates and investment returns for each future year. It is the first step in performing a stochastic forecast.
ProVal includes four alternative approaches to generating a Capital Market Simulation:
Classic Mean/Variance simulator – generally used in situations where liabilities do not depend on interest rates. This model is trivial to calibrate to specified assumptions because the inputs equal the outputs. That is, if you wish Canadian Large Cap equities to have an expected return of 8.0%, and your long term inflation rate is 3.0%, then enter a real return of .048544 (1.08/1.03 -1). For details, please see Classic Mean/Variance Simulation Type.
Multi-Factor Term Structure simulator – used in situations where liabilities do depend on interest rates. Somewhat more difficult to calibrate because the inputs must be coerced to achieve the desired outputs. For details, please see Multi-Factor Term Structure Simulation Type.
Explicit Corporate Yield Curve simulator – offers more detailed specifications for corporate bond spreads over Treasuries (that is, government issued bills and bonds). Other aspects of the simulator follow those of the Multi-Factor Term Structure simulator. For details, please see Explicit Corporate Yield Curve Simulation Type.
Custom option – to import your own simulation results. Generally used when other software is used to generate the trial data or in situations where the trial data from ProVal is exported, manipulated/edited and needs to be brought back into ProVal. For details, please see Custom Simulation Type.
Note that although the term “Treasury” originally was a reference to U.S. Treasury bills and bonds, instead you may simulate bills and bonds of another government entity, such as Government of Canada bonds.
The library of all Capital Market Simulations that exist in the current Project is displayed when you select the Capital Market Simulation command. An asterisk next to the name of a simulation indicates that it has not been run. An unexecuted simulation can be run by clicking its name and then the Run button in the next dialog box. A new Capital Market Simulation can be defined either by clicking an existing simulation, changing one or more parameters and saving it as new, or by clicking the New button.
The items requested are as follows:
Name is the description, by which it will be displayed in the Capital Market Simulation library, of the simulation currently being defined. The name may be any descriptive phrase, including spaces.
Simulation Type may be any of ProVal’s standard types defined above or it may be a custom simulation. Note that each simulation type has different input parameters, so the topics will change depending on which Simulation Type was chosen. Select a topic to edit contains the following entries depending on the simulation type:
Inflation (does not apply to the custom simulator)
Real Rate & Term Premium (multi-factor term structure and explicit corporate yield curve simulators)
Benchmark Yields (classic mean/variance simulator)
Corporate Bond Benchmark Yield (multi-factor term structure simulator)
Explicit Corporate Bond Spreads (explicit corporate yield curve simulator)
Simulated Full Yield Curves (custom simulator)
Years, Trials & Accounting Results (does not apply to the custom simulator)
The Yield Curve button is accessible for the multi-factor term structure and the explicit corporate yield curve simulation types. Click the button to display the values of the initial Treasury spot curve (the yields on zero coupon Treasury bonds of duration t) and yield curve (the yields-to-maturity for Treasury bonds of duration t) for integral durations from 1 to 30 years. Note that these values are based on your parameter settings for inflation, the real rate and term premium. If the explicit corporate yield curve simulation type is selected, the initial corporate spot curve and yield curve also are displayed, based on your parameter settings for the corporate bond spread.
The Export button allows you to export Yield Curves or export the Simulation. Export Yield Curves pertains to the explicit corporate yield curve simulator and is accessible once the simulator has been run. It allows you to export the Treasury and / or corporate yield curves to a ProVal database file, which may then be edited similarly to any other ProVal database file. This file may then be referenced in a custom simulator. Export Simulation lets you export the entire simulation to a .cms file that can be linked to ProVal PS files (.pvps) via the ProVal PS API.
When all of the topics have been completed, click the Run button to generate the capital market simulation (except for a simulation of the custom type, which was generated prior to import). ProVal checks to ensure that the correlation matrix and any other necessary parameters are complete. ProVal will tell you to specify any missing parameter; if no errors are found, ProVal executes the simulation. An indication that the capital market simulation is running, as well as percentage complete and elapsed time, will show on the screen during execution.
Once the run is complete, click the View button to see your input parameters and to display the output. Please note that, regardless of the nature of the inputs (arithmetic or geometric), the output presented when you click this View button will be based on arithmetic returns