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

210 MODELING FINANCIAL SCENARIOSto 3.0%. This result is entirely in line with the specifications ofthe model. The one-month value would be closely aligned withthe initial short-term real interest rate (rinit1). To estimate thisrate, we backed out an estimate of inflation from the observedrisk-free, short-term interest rate. During the summer of 2004,the resulting value of the real interest rate was near 0%. Underthe projections, the initial value would begin to revert to thelong-term mean after one month. The mean of the final value inthe results, after 50 years, is around the mean reversion level forthe long rate (rm2), which is 2.8%.To provide an idea about the range of values for the onemonthreal interest rate, columns 3 and 4 of Table 1 display the1st and 99th percentiles of the distribution in the tenth projectionyear. In 1 percent of the iterations, the one-month real interestrate, on an annualized basis, is less than ¡5:3%. On first observation,this result seems nonsensical. Why would an investor bewilling to lose money, in real terms, by investing at a negativereal interest rate? Instead, an investor would just hold cash ratherthan lose 5.3% a year, after adjusting for inflation. However, thismay not be as unrealistic as it seems. First, this result is the annualizedrate as opposed to the one-month real rate of only ¡0:4%.Second, this return may represent the best return available. If inflationis high, then holding cash would generate an even largerloss. In times of high inflation, the best real return an investorcan receive may be negative. Finally, real interest rates are notobservable. The true real interest rate is the return required, overand above expected inflation, for the specific interval. However,the precise expected inflation rate is unobservable in the financialmarkets.In practice, two approaches have been used for estimating theexpected inflation rate. First, one can use economists’ forecastsof inflation. Economists, though, do not represent investors. Bytraining and occupation, the economists included in the surveysare not at all representative of the general financial market participants.Investors may consider some economists’ forecasts in