Cash Flow approach vs Model Office approach

[Trevor]

Hi,

I am trying to understand if there is any difference at all between the Cash Flow approach and Model Office approach. My understanding is:

Cash Flow approach:

1. We project the cashflow at each time period, the expected income and outgo, hence expected profit (net cashflow at time t).
2. Repeat this for all period, and then discount all the expected profit to t=0
3. Final Result = PV(Income - Outgo)

A deterministic model is used

Model Office approach:
Based on Chapter 28, Section 4.1,

1. Asset and Liabilities are projected forward, and then discounted separately.
2. Assets can include expected investment proceeds in the future, and then discount to t=0
   Alternatively, take Market Value of assets if it is market consistent basis (please correct me if I am wrong)
3. Liability and expenses are dealt as if we are calculating reserves. project future liability and then discount.
4. Final result = PV(Asset)- PV(Liability) - PV(Expenses)

A stochastic model is used for asset and liability.

I am not sure if the differences are:

1. CF method uses a deterministic cashflow, the model office uses stochastic variables
2. CF method discounts the net cashflow at each time period, model office discounts the assets a liabilities before netting them off

The reason I'm asking this is because in Series X assignment, Question X6.3 (ii), it is very tempting to rewrite the bookwork in chapter 28 section 4.1. However I realise the core reading is describing the model office approach, but the question asks for cashflow approach. But what is the difference?

Thanks,
Trevor

 

[Mark Willder]

Hi,

I am trying to understand if there is any difference at all between the Cash Flow approach and Model Office approach. My understanding is:

Cash Flow approach:

1. We project the cashflow at each time period, the expected income and outgo, hence expected profit (net cashflow at time t).
2. Repeat this for all period, and then discount all the expected profit to t=0
3. Final Result = PV(Income - Outgo)

A deterministic model is used

Model Office approach:
Based on Chapter 28, Section 4.1,

1. Asset and Liabilities are projected forward, and then discounted separately.
2. Assets can include expected investment proceeds in the future, and then discount to t=0
   Alternatively, take Market Value of assets if it is market consistent basis (please correct me if I am wrong)
3. Liability and expenses are dealt as if we are calculating reserves. project future liability and then discount.
4. Final result = PV(Asset)- PV(Liability) - PV(Expenses)

A stochastic model is used for asset and liability.

I am not sure if the differences are:

1. CF method uses a deterministic cashflow, the model office uses stochastic variables
2. CF method discounts the net cashflow at each time period, model office discounts the assets a liabilities before netting them off

The reason I'm asking this is because in Series X assignment, Question X6.3 (ii), it is very tempting to rewrite the bookwork in chapter 28 section 4.1. However I realise the core reading is describing the model office approach, but the question asks for cashflow approach. But what is the difference?

Thanks,
Trevor

Hi Trevor

A model office is a type of cashflow model, but there are other cashflow models too.

Cashflow models (including model offices) can be deterministic or stochastic.

We generally talk about cashflow models to contrast with formula models. For example, pricing might use profit testing (a cashflow approach) or a formula (such as the big A and little a factors we have in the yellow tables).

A model office is a model that looks at the entire business, ie all the current policies and perhaps future new business too. Contrast this with a pricing model that looks at just one model point.

Best wishes

Mark

 

[Trevor]

Hi Trevor

A model office is a type of cashflow model, but there are other cashflow models too.

Cashflow models (including model offices) can be deterministic or stochastic.

We generally talk about cashflow models to contrast with formula models. For example, pricing might use profit testing (a cashflow approach) or a formula (such as the big A and little a factors we have in the yellow tables).

A model office is a model that looks at the entire business, ie all the current policies and perhaps future new business too. Contrast this with a pricing model that looks at just one model point.

Best wishes

Mark

Hi Mark,

Thank you for your explanation. It is very clear now.

However referring back to the question I referred to. Do you think it is appropriate to answer it using the core reading in section 4.1 of chapter 28 to answer the question in assignment X6.3?
I think the core reading and the solution X6.3 for this are broadly describing the same points.
Would the core reading texts be an acceptable solution given the wording of the question?

 

[Mark Willder]

Hi Mark,

Thank you for your explanation. It is very clear now.

However referring back to the question I referred to. Do you think it is appropriate to answer it using the core reading in section 4.1 of chapter 28 to answer the question in assignment X6.3?
I think the core reading and the solution X6.3 for this are broadly describing the same points.
Would the core reading texts be an acceptable solution given the wording of the question?

Hi Trevor

I don't think I understand what you are asking here. As you say, the Core Reading and solution are similar. After all section 4.1 is entitled "Using a model office to determine an investment strategy". So yes, the ideas in this section will score. The solution also says that ideas from the modelling chapter will help.

However, you should be careful to write your answer in your own words. You cannot cut and paste from the Core Reading or Course Notes.

In your original post you were worried that the question asked for a cashflow approach, while the solution covers a model office. But as I explained in my reply, a model office is a type of cashflow model.

Best wishes

Mark