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

206 MODELING FINANCIAL SCENARIOSExcluding Negative Nominal Interest RatesThere has been significant debate over the proper way to dealwith negative nominal interest rates in interest rate models. Somemodelers have set boundary conditions that prevent nominal interestrates from becoming negative. Other modelers have notbeen concerned over negative interest rates, either because themathematical characteristics of the model are more importantthan the practical applications or because the incidence of negativenominal interest rates is too infrequent to require significantattention.While it depends on the specific application, the occurrenceof negative nominal interest rates can be problematic. Economically,certain variables have natural limits. For example, whiletheory may not reject negative interest rates, reality suggests thatit is unlikely that investors would ever accept negative nominalinterest rates when lending money. Therefore, the model providesusers with two options:² Placing lower bounds on the levels of inflation and real interestrates. The model simulates these processes as if there were nolower bound, but then it chooses the maximum of the lowerbound and the simulated value.² Eliminating the potential for negative nominal interest rates. Inthis case, the model uses the standard inflation simulation, buteffectively places a lower bound on the real interest rate suchthat the resulting nominal interest rate is non-negative.User-Defined ScenariosThe financial scenario model provides for stochastic simulationof future economic variables, based upon user-specified parametersfor the assumed processes. However, there are instanceswhere it may be desirable to allow the user to input specific scenariosfor the future values of certain processes. For example,regulations may require sensitivity testing based on specific equityreturn patterns over the next decade. The financial scenario