Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

September 2002

Subject 103 — Stochastic Modelling

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.

K G Forman
Chairman of the Board of Examiners
12 November 2002

ã Faculty of Actuaries
ã Institute of Actuaries
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

Questions involving straightforward applications of Markov Chains and Time Series were
well answered, and the standard of answers to questions about martingales and Brownian
motion is improving from year to year, but candidates appeared to experience unexpected
difficulties in relation to the questions on Markov jump processes.

1 (i) Prove this using the Markov property. (Note that this mark can be earned for
use of the property even if the word “Markov” is not mentioned.)

If s0 < s1, … < sn < s < t, then

P[ X t - Xs = j| X s0 = i0, …, X sn = in, Xs = i]

(l(t - s )) j -l(t - s )
= P[ X t = i + j|Xs = i] = e ,
j!

independent of i0, i1, …, in.

(ii) We need to prove that E[ X t | Fs ] = X s .

With s < t we have

E[ X t | Fs ] = E [ X t - X s | Fs ] + E[ X s | Fs ]

= E[ X t - X s ] + X s = l(t - s) + X s .

Thus E[ X t - lt | Fs ] = X s - ls.

The key to part (i) was to use the Markov property; only a few candidates managed to do this
part. Part (ii) was generally well answered.

2 (i) Since the equation can be written (1 - aB) Y = (1 + (1 - a)B)Z, the process is
ARMA(1,1), or ARIMA(1,0,1).

(ii) There are a number of possible ways to calculate the gk, and one way which
sidesteps the gk and calculates the rk directly. The solution presented here is
one of the possible answers; other methods were marked on their merits.

g k = Cov [Yt , Yt -k ] .

Rearrange the time series equation to give Yt = aYt -1 + Zt + (1 - a ) Zt -1

Now Cov[Yt, Zt] = σ2

Page 2
Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

and Cov[Yt, Zt-1] = α.Cov[Yt-1, Zt-1] + Cov[Zt, Zt-1] + (1 – α).Cov[Zt-1, Zt-1]

= α.σ2 + 0 + (1 – α).σ2 = σ2

Therefore

g 0 = Cov [Yt , Yt ] = a.Cov [Yt , Yt -1 ] + Cov [Yt , Z t ] + (1 - a ) .Cov [Yt , Zt -1 ]

= a.g1 + s2 + (1 - a ) .s 2

Þ g 0 = a.g1 + ( 2 - a ) .s2 (1)

g1 = Cov [Yt , Yt -1 ]

= a.Cov [Yt -1, Yt -1 ] + Cov [ Zt , Yt -1 ] + (1 - a ) .Cov [ Zt -1, Yt -1 ]

= a.g 0 + 0 + (1 - a ) .s2

Þ g1 = a.g 0 + (1 - a ) .s2 (2)

substitute for γ0 from (1) into (2)

( )
Þ g1 = a. a.g1 + ( 2 - a ) s 2 + (1 - a ) .s 2

éë( 2 - a ) .a + (1 - a )ùû .s2 æ 1 + a - a 2 ö 2

Þ g1 = =ç .s
1- a2 ç 1 - a 2 ÷÷
è ø

substitute for γ1 back into (1)

Þ g0 = a.
(1 + a - a ) .s
2 2
æ 2 - a2 ö 2
+ ( 2 - a ) .s 2 = ç .s
1- a2 ç 1 - a 2 ÷÷
è ø

For k ³ 2,

g k = Cov [Yt , Yt - k ]

= a.Cov [Yt -1, Yt - k ] + Cov [ Zt , Yt - k ] + (1 - a ) .Cov [ Zt -1, Yt - k ]

= a.g k -1 + 0 + 0

Þ g k = a k -1.g1

Page 3
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

gk
The autocorrelation function is: rk = . Therefore
g0

r0 = 1

1+ a - a2
r1 =
2 - a2

r k = a k -1r1 k³2

Part (i) was generally well answered, using a variety of different approaches. Candidates
generally made good attempts at part (ii), the main problems occurring being a failure to
correctly specify γ0 and algebraic errors in solving the simultaneous equations.

3 (i) If the driver is to have had at least i accidents by time t + dt, either there must
have been i accidents by time t or there must have been exactly i - 1 by time t
and another between t and t + dt.

P (exactly i - 1) = P(at least i - 1) - P(at least i ).

Therefore
dai
= ib(ai-1 - ai).
dt

d
(ii) Verification: {(1 - e-bt)i}= ibe-bt(1 - e-bt)i-1 .
dt

ai-1 - ai = (1 - e-bt)i-1(1 - [1 - e-bt]).

We should also verify that ai(0) is correct: the value should be 0 for i > 0,
which it is.

Then, defining Ti as the time the process first hits i, we have

Ti £ t} - P{Ti +1 £ t} = (1 - e-bt)i - (1 - e-bt)i+1 = e-bt(1 - e-bt)i

P0,i(t) = P {}

(iii) Probably a good suggestion. A driver who has had 2 accidents in 10 years is
less likely to have another than a driver who has had 2 accidents in a month.

(iv) The proposed model does address the issue raised in (iii) but leads to a very
high accident rate when t is close to 0, so is unsuitable.

Many candidates attempted part (i), but were unable to give a sufficiently clear description to
convincingly display their understanding and so did not earn full marks. In some cases,

Page 4
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

candidates did not correctly interpret the definition of ai(t). In part (ii) many candidates tried
to solve the differential equation, where they could instead have simply shown the solution
given to be valid. Candidates generally came up with sensible suggestions for part (iii), but
only a few candidates were able to make suitable comments on part (iv).

4 (i) When volatility is high, dXt is strongly upwards; when volatility is low, dXt is
close to zero.

The first of these fits the assumptions, whereas for the second something more
negative would be preferable. (It looks as though the process X has more
opportunity to increase than to decrease.)

(ii) (a) Itô (time-independent case): if dXt = Ytdt + ZtdBt then

df d2 f
df(Xt) = (Yt dt + Z t dBt ) + ½ 2 Zt2 dt. or simply
dx dx
f '( X t )dX t + ½ f ''( X t )(dX t ) , with an explanation of what is meant by (dXt)2.
2

Equally acceptable is the time-dependent version:

¶f ¶f ¶2 f
df(Xt,t) = dt + (Yt dt + Zt dBt ) + ½ 2 Zt2 dt.
¶t ¶x ¶x

(b) Here

df(Xt) = f ¢( X t )dX t + ½ f ¢¢( X t )(dX t ) 2

= f ¢( X t )[Yt dBt + Yt2 dt ] + ½ f ¢¢( X t )Yt 2 dt

= f ¢( X t )Yt dBt + Yt2 [ f ¢( X t ) + ½ f ¢¢( X t )]dt.

In this instance, df(Xt) = -2e-2 X t Vt dBt .

(c) This is a martingale by the disappearance of the dt term, as E(dBt | Ft) = 0.

Alternatively,

T
e-2 X T = e-2 X 0 - 2ò e-2 X t Vt dBt ,
0

which is a martingale.

(iii) e-2 X 0 = E ( M 0 ) = E ( M t ) = E (e -2 X t ) ³ e -2 E ( X t ) . It follows that E ( X t ) ³ X 0 ,

whatever the initial state.

Page 5
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

This confirms the initial suggestion that downward movements are too
unlikely in comparison to upward ones.

The question generally showed good attempts, with a variety of different but correct versions
of Itô's Lemma being given. The only real problem evident here was in part (iv), where many
candidates failed to use the given inequality to prove the point.

5 (i) Discrete state space, discrete time: Markov chain, simple random walk,
anything like that;
Discrete state space, continuous time: Poisson process, Markov jump process;
Continuous state space, discrete time: time series, general random walk;
Continuous state space, continuous time: Itô process, Brownian motion, etc.

(ii) (a) by definition, is monthly. Therefore a continuous time variable is not

appropriate. Something like a time series would do, containing an element of
Autoregression.

(b) functions in continuous time; Brownian motion, Geometric BM or any

kind of diffusion or Itô process would be a suitable candidate.

(c) has a discrete state space. It would be possible to review the member’s
status only once a year, say in which case a Markov chain would fit, but in the
absence of a remark about frequency of membership status review a
continuous-time model would seem more appropriate; a Markov jump process
is what we might look for.

(iii) (a) Once a model has been decided upon, parameters may be estimated by
standard methods. But it is necessary to check that the model, with
parameters given by their estimated values, has sample paths which
resemble the data actually observed, otherwise incorrect inferences can
be drawn.

(b) Let yi = xi - xi-1 = Ñxi and let nu be the number of time yi = 1. The
parameter, q (or p) is the probability of an up-jump, estimated as
q̂ = nu / (n -1).

We need to check that the yi form a sequence of i.i.d. variables. A test

based on chi-squared is not appropriate except as indicated below.

The test to apply is one which determines whether there is significant

clustering of the +1’s and the -1’s, as opposed to their being randomly
scattered through the sample: the runs test on the yi, or equivalently the
turning points test on the xi, would be fine; a test based on the sample
autocorrelation function or a contingency table (yi = -1 or +1 as the

Page 6
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

row labels, yi+1 = -1 or +1 as the column labels) would also be

acceptable.

In part (i) many candidates gave specific examples of observable processes, rather than
describing the stochastic models themselves as requested in the question; some credit was
however given for these cases. Part (ii) and (iii) (a) generally had good answers. In part
(iii) (b) many candidates incorrectly suggested that a chi-squared test should be used,

6 (i)

(For full credit the probabilities should all be included on the diagram.)

Stationary distribution pA = pT = pP = 0, pD = 1. Derivation not required: the

answer is obvious to anyone who understands.

(ii) The duration of a permanent disability benefit is a geometric r.v., T.

Since P[ X n +1 = P | X n = P] = 0.8, the parameter is 0.2:

1
P[T = n] = (0.8)n-10.2. Accordingly its mean is = 5.
1 - 0.8

(iii) The required probability is obtained from (1 0 0 0)P3.

(1 0 0 0)P = (.75 .1 .05 .1); (1 0 0 0)P2 = (.6125 .105 .0875 .195);
(1 0 0 0)P3 = (.511875 .09275 .111125 .28425).
The solution is .09275 + .111125 = .203875.
(The summation does not have to be performed to earn the mark: giving the
two probabilities separately is a reasonable interpretation of the question.)

(iv) The probability of never visiting T or P starting from A is

0.1 + 0.75 ´ 0.1 + (0.75)2 ´ 0.1 + …

Page 7
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

¥
0.1
= 0.1å (0.75)n = = 0.4.
n=0 1 - 0.75

Most candidates correctly gave the transition graph in part (i), although there were a few
cases where the transition probabilities were not included in the solution. Part (iii) was well
answered. Solutions to (ii) and (iv) were mixed, with perhaps less than a third of students
immediately recognising the required approach and thereby gaining full marks.

7 (i) The three elements are:

· the multiplier — usually denoted a

· the increment — usually denoted c; the increment is often set to zero

(without any loss in the quality of the pseudo-random sequence) to speed
up the generation process

· the modulus — usually denoted m — where m > a and m > c; the

generator will produce a series of pseudo-random numbers with period no
more than m, so the modulus is usually set to as high a number as possible.

The recursive relationship is: Xn+1 = (aXn + c) (mod m) for n = 0, 1, 2, …,

N - 1. We then set xk = Xk/m for each k = 1, 2, …, N.

(ii) Use the inverse transform method:

2
ala 2 æ 1 ö
f(x) = = , so that F(x) = 1 - ç ÷
(l + x)a+1 (1 + x) 3
è 1+ x ø

1
Þx= - 1. , so
1 - F ( x)

· if F(x) = 0.954, then x = 3.6625

· if F(x) = 0.462, then x = 0.3634
· if F(x) = 0.628, then x = 0.6396

(iii) The structure of a Markov jump process implies that the time until the next
jump has exponential distribution, with rate s if the current state is H, r if S.

The even-numbered inter-jump times will have one distribution, the odd-
numbered ones a different one.

Obtain numbers y0, y2, y4, …, y2n by the above procedure, being simulated
outcomes of independent random variables Y0, Y2, Y4, …, Y2n exponentially
distributed with parameter s. Similarly, obtain y1, y3, …, y2n-1 using a
parameter r instead of s.

Page 8
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

Put tj = y0 + y1 + … + yj. Find j such that tj-1 £ t < tj and return

ì H if j is even
xt = í
î S if j is odd

Candidates made reasonable attempts at part (i), although in many cases insufficient detail
was provided to score full marks. Part (ii) was generally well answered, the only problem
here being simple algebraic errors. Part (iii) was not answered well, with candidates on the
whole failing to recognise that the transitions from healthy to sick and from sick to healthy
should be modelled separately and then combined to provide the required process.

8 (i) E ( St - S0 ) = mt , Var( St - S0 ) =s2t.

E ( ST - St ) = m (T - t ), Var( ST - St ) = s2(T - t).
Cov(St - S0, ST - St) = 0, because of the independent increment property of
Brownian motion.

(ii) The expectation is mt - (t/T)mT = 0.

ææ T - t ö t ö
Var(St - Sˆt ) = Var ç ç ÷ ( St - S0 ) - ( ST - St ) ÷
èè T ø T ø

2 2
æT -t ö 2 æ t ö 2 t (T - t )s 2
=ç ÷ s t + ç T ÷ s (T - t ) = .
è T ø è ø T

(iii) The maximum of t(T - t) is attained at t = ½T.

This is not surprising. The graph of St - Sˆt against t is “tied down” at the ends,
as the function is constrained to be equal to zero. The greatest scope for
variation is bound to be in the middle.

(iv) Two possible reasons might be that a Brownian motion can become negative,
which a stock price cannot, and that fluctuations in the value of a stock price
are usually proportional to the price. Other reasons could also apply.

Under the revised model ln(St) has the same structure as St in the original
model, so ln(St) will have its greatest variability at ½T. The result will not
differ greatly from the result above.

Candidates generally gave good answers for part (i). However, answers to part (ii) and (iii)
were disappointing, particularly for part (iii) where the answer can be derived very simply
from general reasoning. Part (iv) in general showed better answers, although many
candidates failed to get full marks because they did not discuss how their response to (iii)
would differ under the new model.

Page 9
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

9 (i) Xt = m + a(Xt-1 - m) + et + bet-1 is the equation.

The parameters are a (the autoregressive parameter), b (the moving average

parameter), m (the mean level) and s (the innovation standard deviation).

(ii) (a) Calculate theoretical ACF r1, r2 of ARMA(1, 1) in terms of a and b.

Find sample ACF r1, r2 from the data. The required estimates are the
values of a and b which ensure that r1 = r1 and r2 = r2.
The value of s2 is estimated using for example the calculated value of
g0 and the sample variance.

(b) The assumptions are that the en are independent and Normally
distributed.

(c) MLE in this case tries to minimise å et2 . Now et can be expressed as
a function of xt, xt-1 and et-1. et-1 is unknown, but can be expressed as
a function of xt-1, xt-2 and et-2, etc. We need to estimate a suitable
value of e0.

This is done iteratively: assume that e0 = 0 and estimate parameters on

that basis; then use forecasting techniques on the time-reversed process
{xn, xn-1, …, x1} to gain a more accurate estimate of e0; repeat this
process until everything converges.

(iii) (a) xˆ20 (1) = 5.67 + 0.61(8.2) + 0 - 0.23(-1.38) = 10.99.

xˆ20 (2) = 5.67 + 0.61(10.99) + 0 - 0 = 12.37.

(b) For exponential smoothing the equation is

xˆ20 (1) = xˆ19 (1) + a ( x20 - xˆ19 (1)) = 8.37 + 0.2(-0.17) = 8.34.

(c) A variety of exponential smoothing might be better if the mean

changes by some means other than a linear trend, or if there is
multiplicative seasonal variation.

In part (i) a number of candidates omitted σ from the list of parameters. Part (ii) (a) showed
some good answers, however in most cases insufficient details was provided to earn full
marks. Part (ii) (c) was very poorly answered, with very few candidates showing that they
understood the concept of backforecasting. In part (iii) most candidates understood what
was generally required, though in some cases there were errors in applying the formulae.

10 (i) P10 ( t + h ) = (1 - rh ) .P10 ( t ) + s.h.P11 ( t )

d
Þ P10 ( t ) = - r.P10 ( t ) + s.P11 ( t ) (1)
dt

Page 10
Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

and

P11 ( t + h ) = r.h.P10 ( t ) + (1 - s.h ) .P11 ( t )

d
Þ P11 ( t ) = r.P10 ( t ) - s.P11 ( t ) (2)
dt
[(2) also follows from the fact that P10 ( t ) + P11 ( t ) = 1 .]

(ii) P10 ( t ) + P11 ( t ) = 1

d
so from (1) P10 ( t ) + ( s + r ) .P10 ( t ) = s
dt

d ( s+r )t
P10 ( t ) = s.e( ) + C
s+r t
Þ e
dt

s
.e( ) + C.e ( )
s+r t - s+r t
Þ P10 ( t ) =
s+r

Þ P10 ( t ) =
s
s+r (
. 1- e ( )
- s+r t
) since P10(0) = 0.

[Alternatively, instead of solving the DE, just verify that the function
proposed as the solution does indeed satisfy the DE and also check that the
value is correct at t = 0.]

Therefore

r + se ( )
- s+r t
P11 (t ) = 1 -
s
s+r (
. 1- e ( ) =
- s+r t
)
s+r
.

(iii) (a) The generator matrix is now

æ -r r 0 ö
ç ÷
ç s - (s + r) r ÷
ç 0 2s -2s ÷ø
è

(b) Hence the Forward Equations are

d
p0 ( t ) = - r. p0 ( t ) + s. p1 ( t )
dt

d
p1 ( t ) = r. p0 - ( s + r ) p1 ( t ) + 2.s. p2 (t )
dt

Page 11
 Subject 103 (Stochastic Modelling) — September 2002 — Examiners’ Report

d
p2 ( t ) = r. p1 ( t ) - 2s. p2 ( t )
dt

(c) Simply substituting in the suggested values gives the required result.

(d) The implication is that the given distribution is stationary. By the

standard properties of Markov processes, it follows that it is the
equilibrium distribution, so that the long-term probabilities of being in
each of the three states are known.

Answers to this question were on the whole disappointing.

Problems in part (i) included transposing the parameters. Marks were available for deriving
p11 from p10 (using the information given in the question) even where p10 could not be
correctly identified.

Only a small proportion of candidates managed to provide a solution for the differential
equation in part (ii).

Better answers were given for the generator matrix in part (iii).

Candidates that gave a generator matrix by and large were able to score marks by applying
their matrix to produce the forward equations. Very few candidates provided any
conclusions under part (iv).

Page 12