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cenarios represent the set of possible future outcomes of the random parameters of the model at hand over the decision horizon. Since the number of scenarios can be very large, procedures to reduce their number while still retaining their representation of the future are of interest. So are ways to generate scenarios from given distributions. In this second of three columns, I discuss two basic mathematical approaches to accomplish this. The third column will discuss how economic models, especially those relating to interest rates, earnings and other key economic variables can be used to generate scenarios that tilt the past towards more likely futures. The first way is that scenarios can be generated by moment matching. The idea is that the reduced set of scenarios has the same moments as the original larger set of scenarios to some order. We used this idea in the five period Russell-Yasuda Kasai insurance model in 1989 which is discussed in Cario, Myers and Ziemba (1998). Smith (1993), Keefer and Bodily (1993), Keefer (1994) have suggested such methods for static problems. Hyland and Wallace (HW) (2001) have expanded and refined the idea for multiperiod problems and they generate scenarios that match some moments of the true distribution. Typically it is the first four moments. Extension of the HW work are in Hyland, Kaut and Wallace (2001) and Kouwenberg (1999).
The procedure is easy to use and provides adequate scenarios. It does have its faults because the two distributions in Figure 1 have the same first four moments.1 Such mathematical mismatches aside, the HW approach is to find a set of discrete scenarios that best fits the distributions first four moments minimizing least squares. The scenario tree consists of realizations and their probabilities of all random parameters in all time periods. The optimization problem is min w i ( fi ( s, p ) Q i ) 2
x ,p i Q
M = 1 0
-4
-3
-2
-1
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where Q is the set of all specified statistical properties and Qi the value of i Q , with weight wi , M is a matrix of zeros and ones, whose number of rows equals the length of and whose number of columns equals the number of nodes in the scenario tree. Each column in M provides a conditional distribution at a node in the scenario tree. HWs examples, single and multiple period, consider four asset classes - cash, bonds, domestic stocks and international stocks and the expectations are in terms of the interest rate for cash and bonds and total returns for stocks. The decision maker must specify their (subjective) expectations for the marginal distributions. This is a preferred way to solicit experts future views of key model parameters. Various methods exist for eliciting these distributions. For calculations, HW use the NAG C library routine which, however, does not guarantee that the second derivative does not change sign. Figure 2 shows fitted cumulative distribution functions for the four asset classes and their corresponding derived density functions (some with odd shapes) where the specified percentiles are denoted by triangles. The aim is to construct the return r and the probabilty p so that the statistical properties match those of the specified distribution. Once these are estimated the scenarios can be generated. The properties of the marginal distributions in the HW example are shown at the top left of this page. The normal distribution has a kurtosis of three. A kurtosis of less than three means that the distribution is less peaked around the mean than the normal distribution. The correlations are shown at the top right of this page. A set of six scenarios that exactly match the expected return, standard deviation and correlation data in these tables is shown in Figure 3
Figure 2: Fitted cumulative distribution functions and the derived density functions for the asset classes
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Figure 3: Six scenarios that match the expected return, standard deviation and correlation data of the HW example
Interest rate / total return
20 10 0
Empirical studies, starting with Fischer Black in the 1970s show that the volatility for stocks increases after a large decrease in stock prices, but not after a large increase
where MRF i [0, 1] is the mean reversion factor (the higher the more mean reversion), MRL i is the mean reversion level and ri,t the interest rate for bond class i in period t. Mean reversion means that interest rates tend to revert to an average level. The assumption is that when interest rates are high, the economy slows down, and interest rates tend to fall and when interest rates are low, the economy improves and interest rates rise. Empirical studies, starting with Fischer Black in the 1970s show that the volatility for stocks increases after a large decrease in stock prices, but not after a large increase. Modeling this asymmetry is straightforward, but to simplify the presentation, HW assume equal volatility dependencies for all asset classes. For stock, HW assume that there is a premium in terms of higher expected return which has associated with it more risk. The expected return is then ri,t = rft + RPt it where rft is the risk-free interest rate, it is the standard deviation and RPt is a risk premium constant for period t. For period 1, the assumptions are as in figure 3. For periods 2 and 3, the expected values and standard deviations are state dependent as modeled here. Other factors are assumed to be state independent and equal to the specifications in period 1. Correlations are as in period one for all three periods. These market expectations are summarized to the left.. The risk premium RPt = 0.3 for t 1, 2, 3. The volatility clumping parameter ci = 0.3 for all assets, the mean reversion factor MRF i = 0.2 for all interest rate classes and the mean reversion level MRL i = 4% and 5.8% for cash and bonds, respectively.
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8.509
42.190
where the worst case event is given in the left most scenario. Moving from static one-period scenarios to dynamic multiperiod scenarios has several added complexities such as intertemporal dependencies that need to be considered. These include volatility clumping and mean reversion. Multiperiod scenario trees must either have independence across time or more likely have an
intertemporal dependence structure. For example, HW assume that the volatility for asset class i t > 1 is in period it = ci ri,t1 ri,t1 + (1 ci )Ait where ci [0, 1] is a volatility clumping parameter (the higher the more clumping), ri,t is the real ized return with expectation ri,t and Ait is the average standard deviation of asset i in period t. They model mean reversion of the two bond classes using ri,t = MRF i MRL i + (1 MRF i )ri,t1
Domestic stocks
International stocks
Distribution property expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event expected value of spot rate standard deviation skewness kurtosis worst-case event
(end of) Period 1 4.33% 0.94% 0.80 2.62 6.68% 5.91% 0.82% 0.49 2.39 7.96% 7.61% 13.38% -0.75 2.93 -25.84% 8.09% 15.70% -0.74 2.97 -31.16%
(end of) Period 2 State dep State dep 0.80 2.62 State dep State dep State dep 0.49 2.39 State dep State dep State dep -0.75 2.93 State dep State dep State dep -0.74 2.97 State dep
(end of) Period 3 State dep State dep 0.80 2.62 State dep State dep State dep 0.49 2.39 State dep State dep State dep -0.75 2.93 State dep State dep State dep -0.74 2.97 State dep
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0.359 0.064 0.067 0.234 0.372 0.094 0.055 0.056 -0.08 -0.37
0.023 0.037 0.063 0.31 0.506 0.492 0.053 0.058 0.225 0.236
0.262 0.044 0.069 0.2 0.359 0.024 0.063 0.051 -0.26 -0.01
0.293 0.027 0.042 0.023 0.03 0.401 0.035 0.042 0.163 0.182
The HP method combines a good approximation of the moments and the tails
This approach will render infeasible one period subtrees that lead to conditional multiperiod trees that do not have a full match. The drawback is a much more difficult optimization problem. A three-period scenario tree that has a perfect match with these specifications was generated in 63 seconds on a Sun Ultra Sparc 1 (each single period tree takes less than a second to construct). The first two scenarios which have a perfect match are shown at the top left of this page. HW found also that stability (the same objective value for different scenario trees) is improved by solving for larger scenario trees by aggregating several smaller scenario trees. See Hyland and Wallace (2001b) and Hyland, Knut and Wallace (2001) for more discussion. The second approach, due to Hochreiter and Pflug (HP) (2002), generates scenario trees using a multidimensional facility location problem that minimizes a Wasserstein distance measure from the true distribution. Moment matching can yield strange distributions. Hence they propose this alternative approach which approximates distributions with very few scenarios. The Kolmogorov-Smirnov (KS) distance approximations is an alternative approach but it does not take care of tails and higher moments. The HP method combines a good approximation of the moments and the tails. An example is the t-distribution with two degrees of freedom with density (2 + x2 )3/2 . This density is approximated in Figure 4 with the KS distance on the left and the Wasserstein distance on the right. The latter gives better approximations, the location of the minimum is closer to the true value and the
0.332 0.09 0.043 0.061 0.081 0.095 0.198 -0.3 0.128 -0.19
0.214 0.101 0.182 0.049 0.04 0.061 0.072 0.06 0.064 0.046 -0.21 0.021 -0.01 0.079 0.044
There are alternative ways of constructing the multiperiod trees. Hyland and Wallace use a sequential procedure: (1) specify statistical properties for the first period and generate first-period outcomes; (2) for each generated first-period outcome, specify conditional distribution properties for the second period and generate conditional second-period outcomes. Continue specifying conditional distributions to generate consistent outcomes in all periods. This approach has numerical advantages from the decompositon into single-period trees. Each single-period
optimization problem is nonconvex., However, by adjusting the number of outcomes and reoptimizing from alternative starting points, usually ensures that a perfect match is obtained for each of the generated single-period trees if one exists. This sequential approach requires the distribution properties to be specified at each node in the tree. Hence, the approach does not control the statistical properties over all realizations in periods t = 2, 3, . . .. An alternative is to construct the entire tree in one large optimization.
Figure 4: Approximation of a t-distribution with a Kolmogorov-Smirnov distance on the left and the Wasserstein distance measure on the right
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mean is closer as well. Observe how few scenarios are used for the approximations. The KS distance is invariant with respect to monotone transformations of the x-axis and thus does not approximate the tails well like the Wasserstein distance. The optimal approximation of a continuous distribution G by a distribution with mass points z1 , . . . , zm with probabilities p1 , . . . , pm using the KS distance is
zi = G1
2i 1 2m , pi = 1 . m
Scenario Tree
0.998 (0.368)
1.041 (0.4521)
This yields the scenario trees in Figure 6 and 8 and the scenario simulation in Figure 7. In the third scenario column I will discuss how various economic models, especially those with interest rates, earnings, etc involved and expert judgment can be used to tilt existing scenarios, based on past data, towards more likely future scenarios. Figure 5 shows the scenario generation procedure. An example follows 1.19 1.05 0.92 for stocks which return with probabilities 0.23 0.48 0.29 which return 1.055 1.04 1.03 and bonds with probabilities 0.22 0.52 0.26. The bond-stock correlation is 0.4 so the joint probability matrix is 1.19 1.05 0.92 1.055 0.0154 0.2146 0 1.04 0 0.3054 0.1746 1.03 0.2046 0 0.0854
0.959 (0.3097)
1.035 (0.2637)
1.038 (0.501) 1.039 (0.506) 1.0365 (0.502) 1.032 (0.499) 1.0345 (0.513) 1.0305 (0.487)
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1.049/1.035 (0.1974)
0.998/1.041 (0.4010)
0.959/1.048 (0.2171)
0.959/1.035 (0.0889)
REFERENCES
s Cario, D., R. Myers, and W. T. Ziemba (1998). Concepts, technical issues and uses of the Russell-Yasuda Kasai financial planning model. Operations Research 46, 450462. s Heyde (1963). s Hochreiter and Pflug (2002). s Hyland, K. , M. Kaut, and S. W. Wallace (2001). A heuristic for generating scenario trees for multistage decision problems. Stochastic programming e-print series. s Hyland, K. and S. W. Wallace (2001). Generating scenario tress for multistage decision problems. Management Science 47, 295307. s Keefer, D. L. (1994). Certainty equivalents for three-point discrete-distribution approximations. Management Science 40, 760773. s Keefer, D. L. and S. E. Bodily (1983). Three-point approximations for continuous random variables. Management Science 29, 595609. s Kouwenberg, R. (1999). Scenario generation and stochastic programming models for asset liability management. European Journal of OR. s Smith, J. E. (1993). Moment methods for decision analysis. Management Science 39, 340358. 1 X is uniform on [ 3,
3], and 3Z 5
Y=
3I 5
1/4
where I is -1 or +1 with probability 0.5 and Z is N (0, 1). Then E [x ] = E [y ] = 0 , E [x 2 ] = E [y 2 ] = 1 , E [x 3 ] = E [y 3 ] = 0 and E[x4 ] = E[y4 ] = 9/5. Hochreiter and Pflug (2002) derived this example using ideas from Heyde (1963) who showed that even infinite moment matching would not replicate all distributions.
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