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Ch 18, Section 1.2 - Market Consistency

  • Thread starter dazed and confused
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dazed and confused

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I am confused by the core reading on page 9 of chapter 18 (Setting Assumptions - Investment Return - Market Consistency).

The first paragraph says:
"If a market-consistent approach (as described in Section 3 of Chapter 15) is used, either deterministically or stochastically, then the expected investment return can be set as the risk-free rate, irrespective of the actual underlying assets held (this is the "risk neutral" calibration approach)."

However, in the next paragraph it appears to contradict itself:
"However, if the stochastic approach is adopted, then the investment return volatility and correlation assumptions do remain dependent on the actual underlying asset type(s)?":confused:

Reading through Chapter 15 Section 3, it doesn't appear to mention anything about a stochastic market-cosistent approach...

Could someone help to clarify what the core reading is trying to say here?

Thanks!
 
I am confused by the core reading on page 9 of chapter 18 (Setting Assumptions - Investment Return - Market Consistency).

The first paragraph says:
"If a market-consistent approach (as described in Section 3 of Chapter 15) is used, either deterministically or stochastically, then the expected investment return can be set as the risk-free rate, irrespective of the actual underlying assets held (this is the "risk neutral" calibration approach)."

However, in the next paragraph it appears to contradict itself:
"However, if the stochastic approach is adopted, then the investment return volatility and correlation assumptions do remain dependent on the actual underlying asset type(s)?":confused:

Reading through Chapter 15 Section 3, it doesn't appear to mention anything about a stochastic market-cosistent approach...

Could someone help to clarify what the core reading is trying to say here?

Thanks!

Hi

Good question/challenge.

Short answer

There's a distinction between a central/expected scenario and the distribution around the central scenario. The former can be determined irrespective of the actual assets held; the latter must consider the actual assets held.

Long answer

1. The investment return volatility and correlation assumptions will affect the DISTRIBUTION of the results around the central/expected scenario. The distriution of the results will therefore be affected by the underlying assets held.

2. However in a market consistent world we KNOW what the value of the asset is; it's the market price. Therefore whether a deterministic or stochastic model is used doesn't matter because we are constrained (in a central scenario) by the knowledge that the market has already told us what the price is.

3. For e.g, take two assets: equity & government bonds both valued at £100. In a market consistent world both would be recorded at £100 on the balance sheet (the fact that one is riskier than the other is irrelevant). However, both would have very different DISTRIBUTIONS because equities are riskier than gov. bonds.
 
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