Generating Consistent Real World and Risk Neutral Interest Rate Scenarios

Background and Purpose

Financial risk models for insurance companies and other financial entities have two primary requirements:

• To accurately reproduce the current market prices of various tradable securities including financial derivatives.
• To reasonably project the future states of such tradable assets and various financial variables, with estimates of the associated probability distributions.

The first requirement ensures that the model accurately reflects the current state of the entity’s balance sheet, while the second requirement provides for the levels of various contractual and optional payments, the values of future balance sheets, and the associated likelihoods.

These requirements are interconnected, since the prices of tradable assets cannot be independent of reasonable estimates of the future states of contractual payments. For certain asset classes such as equities and currencies and the associated financial derivatives, the traditional pricing models are often derived from such real-world models, and so both requirements above can be achieved together for such assets.

For interest rates and fixed income security pricing, the subject of this RFP, the connection between risk-neutral pricing and real-world projections has proven difficult if not impossible to tractably establish.

Fixed income pricing is generally addressed within the framework of a “risk neutral world.” There are many models of future interest rates that can be specified within this framework, but the levels of such rates and the associated risk-neutral probabilities that obtain current prices are often unrealistic in the “real world.” The advantage of this approach is that risk neutral pricing can largely be implemented with tractable parameter estimations, without explicitly modeling the more complex market attitudes toward risk.

Research Objective

The Society of Actuaries Investment Section and Committee on Finance and Risk Management Research are seeking researchers to investigate consistent models for interest rate scenarios that can be calibrated for risk-neutral pricing, as well as for real-world projections. In addition to identifying current solutions, the sponsors also seek researchers to identify topics for future research that will further the accuracy, flexibility, and/or tractability of these models.

The following are examples of proposed topics that may be addressed:

• Literature review 1: What, if any, solutions to the above problem exist in the current finance literature?
• Literature review 2: Have promising partial solutions been proposed that the current researchers can further investigate to refine?
• Is there a compelling framework that has evolved for solving this problem?
  • How can a model of future rates be calibrated and/or evaluated in terms of being “real-world”?
  • Given a risk-neutral model with realistic future rates, how can one define what is meant by a “consistent” real-world probability structure?
  • Given a realistic model of future rates, how can a risk-neutral model be derived that reasonably prices current securities?
  • Can such interest rate models be calibrated in multiple currencies in a consistent way?
• For any of the above questions, are there solutions in theory that have limiting computational constraints? Are these constraints hardware-based, or require currently unavailable solution algorithms amenable to future research?

The list above is not meant to be exhaustive but merely examples of proposed topics that may be researched.

Proposal Requirements

To facilitate the evaluation of proposals, the following information should be submitted:

1. Resumes of the researcher(s), including any graduate student(s) expected to participate, indicating how their background, education and experience bear on their qualifications to undertake the research. If more than one researcher is involved, a single individual should be designated as the lead researcher and primary contact. The person submitting the proposal must be authorized to speak on behalf of all the researchers as well as for the firm or institution on whose behalf the proposal is submitted.
   
   
2. An outline of the approach to be used (e.g. literature search, model, etc.), emphasizing issues that require special consideration. Details should be given regarding the techniques to be used, collateral material to be consulted, and possible limitations of the analysis.
   
   
3. A description of the expected deliverables and any supporting data, tools or other resources.
   
   
4. Cost estimates for the research, including computer time, salaries, report preparation, material costs, etc. Such estimates can be in the form of hourly rates, but in such cases, time estimates should also be included. Any guarantees as to total cost should be given and will be considered in the evaluation of the proposal. While cost will be a factor in the evaluation of the proposal, it will not necessarily be the decisive factor.
   
   Please note that as a policy, the SOA Research Institute generally does not provide funding to cover academic institution overhead expenses.
   
   As a guide for developing the project budget, please review the Historical Project Cost Guide (see Appendix)
   
   
5. A schedule for completion of the research, identifying key dates or time frames for research completion and report submissions. The sponsors interested in completing this project in a timely manner. Suggestions in the proposal for ensuring timely delivery, such as fee adjustments, are encouraged.
   
   
6. Other related factors that give evidence of a proposer's capabilities to perform in a superior fashion should be detailed.

Selection Process

The sponsors will appoint a Project Oversight Group (POG) to oversee the project. The sponsors are responsible for recommending the proposal to be funded. Input from other knowledgeable individuals also may be sought, but the sponsors will make the final recommendation, subject to Society of Actuaries Research Institute (SOA) leadership approval. An SOA staff research actuary will provide staff actuarial support.

Questions

Any questions regarding this RFP should be directed to Research-AR@soa.org.

Notification of Intent to Submit Proposal

If you intend to submit a proposal, please email written notification by December 15, 2024 to Research-AR@soa.org.

Submission of Proposal

Please email your proposal to Research-AR@soa.org; proposals must be received no later than January 8, 2025. It is anticipated that all proposers will be informed of the status of their proposal by the end February 2025.

Conditions

The selection of a proposal is conditioned upon and not considered final until a Letter of Agreement is executed by both the Society of Actuaries Research Institute and the researcher.

The Society of Actuaries Research Institute reserves the right to not award a contract for this research. Reasons for not awarding a contract could include, but are not limited to, a lack of acceptable proposals or a finding that insufficient funds are available. The Society of Actuaries Research Institute also reserves the right to redirect the project as is deemed advisable.

The Society of Actuaries Research Institute plans to hold the copyright to the research and to publish the results with appropriate credit given to the researcher(s).

The Society of Actuaries Research Institute may choose to seek public exposure or media attention for the research. By submitting a proposal, you agree to cooperate with the [Society of Actuaries/sponsoring entity] in publicizing or promoting the research and responding to media requests.

The Society of Actuaries may also choose to market and promote the research to members, candidates and other interested parties. You agree to perform promotional communication requested by the Society of Actuaries Research Institute, which may include, but is not limited to, leading a webcast on the research, presenting the research at an SOA meeting, and/or writing an article on the research for an SOA newsletter.

Conflict of Interest

You agree to disclose any of your material business, financial and organizational interests and affiliations which are or may be construed to be reasonably related to the interest, activities and programs of the Society of Actuaries Research Institute.

Appendix

The cost ranges below are intended as a guide for budgeting project costs for proposals in response to SOA Research Institute Request for Proposals (RFP). Please note these figures span the 33rd to 66th percentiles for all projects as well as projects that involve a specific approach (lit review, survey, etc.). They are based on historical costs over several recent years. Expected costs for some RFPs may fall outside these ranges depending on the nature of the work and resources required for completion.

All Contracted Projects

This category includes all contracted projects that the Institute has undertaken within the last several years.

The 33^rd-66^th percentile project costs range is $25,000 - $50,000.

Literature Reviews

This category includes projects that involved only a literature review or the cost for the portion of a larger project that included a literature review.

The 33^rd-66^th percentile project costs range is $15,000 - $20,000.

Surveys

This category includes all projects that had a survey as their primary component.

The 33^rd-66^th percentile project costs range is $28,000 - $55,000.