How can an economic scenario generation model cope with abrupt changes in financial markets?
China Finance Review International
ISSN: 2044-1398
Article publication date: 31 May 2021
Issue publication date: 2 August 2021
Abstract
Purpose
It is quite possible that financial institutions including life insurance companies would encounter turbulent situations such as the COVID-19 pandemic before policies mature. Constructing models that can generate scenarios for major assets to cover abrupt changes in financial markets is thus essential for the financial institution's risk management.
Design/methodology/approach
The key issues in such modeling include how to manage the large number of risk factors involved, how to model the dynamics of chosen or derived factors and how to incorporate relations among these factors. The authors propose the orthogonal ARMA–GARCH (autoregressive moving-average–generalized autoregressive conditional heteroskedasticity) approach to tackle these issues. The constructed economic scenario generation (ESG) models pass the backtests covering the period from the beginning of 2018 to the end of May 2020, which includes the turbulent situations caused by COVID-19.
Findings
The backtesting covering the turbulent period of COVID-19, along with fan charts and comparisons on simulated and historical statistics, validates our approach.
Originality/value
This paper is the first one that attempts to generate complex long-term economic scenarios for a large-scale portfolio from its large dimensional covariance matrix estimated by the orthogonal ARMA–GARCH model.
Keywords
Acknowledgements
The author is grateful to the Ministry of Science and Technology for its financial support (project number MOST 108‐2410‐H‐004‐081‐MY3). All authors are grateful to the assistance provided by Yu-Ching Li during the early stage of the research.
Citation
Lee, Y.-H., Hsieh, M.-H., Kuo, W. and Tsai, C.J. (2021), "How can an economic scenario generation model cope with abrupt changes in financial markets?", China Finance Review International, Vol. 11 No. 3, pp. 372-405. https://doi.org/10.1108/CFRI-03-2021-0056
Publisher
:Emerald Publishing Limited
Copyright © 2021, Emerald Publishing Limited