PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

182 MODELING FINANCIAL SCENARIOSHistorical Interest Rate MovementsOther research reviews historical interest rate movements inan attempt to determine general characteristics of plausible interestrate scenarios. Ahlgrim, D’Arcy, and Gorvett [3] reviewhistorical interest rate movements from 1953 to 1999, summarizingthe key elements of these movements. Chapman and Pearson[12] provide a similar review of history in an attempt to assesswhat is known about interest rate movements (or at least whatis commonly accepted) and what is unknown (or unknowable).Litterman and Scheinkman [32] use principal component analysisto isolate the most important factors driving movements ofthe entire term structure. Some of the findings of these studiesinclude² Short-term interest rates are more volatile than long-term rates.Ahlgrim, D’Arcy, and Gorvett [3] use statistics (such as standarddeviation) to show that long-term rates tend to be somewhattethered, while short-term rates tend to be much moredispersed. (A graphical presentation of historical interest ratemovements is available at http://www.business.uiuc.edu/»sdarcy/present/casdfa3/GraphShow.exe.)² Interest rates appear to revert to some “average” level. For example,when interest rates are high, there is a tendency forrates to subsequently fall. Similarly, when rates are low, theylater tend to increase. While economically plausible, Chapmanand Pearson [12] point out that due to a relatively short historyof data, there is only weak support for mean reversion. Ifanything, evidence suggests that mean reversion is strong onlyin extreme interest rate environments (see also Chapman andPearson [11]).² While interest rate movements are complex, 99% of the totalvariation in the term structure can be explained by three basicshifts. Litterman and Scheinkman [32] show that over 90% ofthe movement in the term structure can be explained by simpleparallel shifts (called the level component). Adding a shift in