THE UNIVERSITY OF NEW SOUTH WALES

MONTH OF EXAMINATIONS - NOVEMBER 2006

ACTL 2003
STOCHASTIC MODELS
FOR ACTUARIAL APPLICATIONS
FINAL EXAMINATION

1. TIME ALLOWED - 3 HOURS.

2. TOTAL NUMBER OF QUESTIONS - 8.
3. ANSWER ALL QUESTIONS.
4. ALL QUESTIONS ARE NOT OF EQUAL VALUE.
5. TOTAL POINTS - 100.
6. ANSWER EACH QUESTION BEGINNING IN A SEPARATE BOOKLET. CLEARLY
INDICATE THE QUESTION NUMBER ON THE FRONT PAGE OF EACH BOOKLET.
7. CANDIDATES MAY BRING THE FORMULAE AND TABLES FOR ACTUARIAL
EXAMINATIONS BOOKLET INTO THE EXAMINATION.
8. CANDIDATES MAY BRING THEIR OWN CALCULATORS.

ANSWER EACH QUESTION BEGINNING IN A SEPARATE BOOKLET.

ALL ANSWERS MUST BE WRITTEN IN INK. EXCEPT WHERE THEY
ARE EXPRESSLY REQUIRED, PENCILS MAY BE USED ONLY FOR DRAWING, SKETCHING OR GRAPHICAL WORK.

Question 1 (16 marks)

For a given driver, any period j is either accident free (Yj = 0) or gives rise to one accident
(Yj = 1). The probability of having no accident during the next period is estimated using
the drivers past record as follows (all values yj are either 0 or 1):
Pr[Yn+1 = 0|Y1 = y1 , Y2 = y2 , . . . , Yn = yn ] = pe(y1 +y2 ++yn ) ,
where 0 < p < 1, 0. The cumulative number of accidents suffered by the driver over the
time from period 1 up to period n is
Xn =

n
X

Yj .

j=1

(i) (4 marks) Verify that the Markov property holds for X1 , X2 , . . . , Xn , . . . and explain
why the sequence Y1 , Y2 , . . . , Yn , . . . does not form a Markov chain.
(ii) (2 marks) Write down the transition matrix of the Markov chain X.
(iii) Determine, being careful to explain your reasons in each case:
(a) (1 mark) whether the Markov chain X is time-homogeneous
(b) (1 mark) whether it is irreducible
(c) (2 marks) whether it admits a stationary probability distribution
(iv) (1 mark) Starting from the state Xt = j, calculate the probability of suffering no
further accident for the next n successive periods.
(v) Suppose you are provided with full claims records for a number of a companys policy
holders.
(a) (2 marks) Describe a method for estimating the parameters and p
(b) (3 marks) Explain how to test the assumption that the probability of an accident
depends only on the cumulative number of accidents, Xn , and does not have a
direct dependence on n.

Question 2 (5 marks)
Policyholders of a certain insurance company have accidents at times distributed according
to a Poisson process with rate . The amount of time from when the accident occurs until
a claim is made has distribution G.
(i) (3 marks) Find the probability there are exactly n incurred but as yet unreported
claims at time t.
(ii) (2 marks) Suppose that each claim amount has distribution F , and that the claim
amount is independent of the time that it takes to report the claim. Find the expected
value of the sum of all incurred but as yet unreported claims at time t.

Question 3 (10 marks)

(i) (2 marks) Demonstrate that the random variable

1
X = log(U )
4
has an exponential distribution with mean
range (0, 1).

1
4

when U is uniformly distributed over the

(ii) (a) (2 marks) Explain how the above can be used to simulate a path of the Poisson
process with intensity = 4.
(b) (2 marks) Derive a method for simulating a Poisson random variable with mean
4.
(iii) (2 marks) Describe an alternative method for generating a Poisson random variable
with mean 4 based on the cumulative distribution function.
(iv) (2 marks) State, giving reasons, which of the two methods in (ii) and (iii) would be
more efficient if a simulation calls for a large number of Poisson random variables with
mean 4.

Question 4 (12 marks)

Marital status is considered using the following time-homogeneous, continuous time Marksov
jump process:
the transition rate from unmarried to married is 0.1 per annum
the divorce rate is equivalent to a transition rate of 0.05 per annum
the mortality rate for any individual is equivalent to a transition rate of 0.025 per
annum, independent of marital status
The state space of the process consists of five states: Never Married (N M ), Married (M ),
Widowed (W ), Divorced (DIV ) and Dead (D).
Px is the probability that a person currently in state x, and who has never previously been
widowed, will die without ever being widowed.
(i) (2 marks) Construct the generator matrix for this process.
(ii) (2 marks) Show, by general reasoning or otherwise, that PN M equals PDIV .
(iii) (4 marks) Demonstrate that:
1 4
+ PM
5 5
1 1
= + PDIV
4 2

PN M =
PM

(iv) (2 marks) Calculate the probability of never being widowed if currently in state N M .
(v) (2 marks) Suggest two ways in which the model could be made more realistic.

Question 5 (13 marks)

(i) (2 marks) Define standard Brownian motion Bt , t 0.
Let St defined represent a share price at time t.
(ii) (3 marks) Solve the stochastic differential equation
dSt = St dt + St dBt .
(iii) (4 marks) Calculate, given the parameters = 25% p.a., = 20% on an annual
basis, the probability that the share price will exceed 45 in four months time given
that its current price is 38.
(iv) (4 marks) Calculate the probability that the share price will exceed 45 at any stage
during the next four months given that its current value is 38.
[You may use the formula
Pr[ max (Bs + s ) > y] = G
0st

t y

+e

2y

y t

where y 0 and G denotes the normalised Gaussian probability distribution function.]

Question 6 (13 marks)

In the Vasicek model, the spot rate of interest is governed by the stochastic differential
equation
drt = a(b rt )dt + dBt ,
where Bt is a standard Brownian motion and a, b > 0.
(i) A stochastic process {Ut : t 0} is defined by Ut = eat rt .
(a) (2 marks) Derive an equation for dUt .
(b) (2 marks) Solve the equation to find Ut .
(c) (2 marks) Show that
rt = b + (r0 b)e

at

ea(st) dBs .
0

(ii) (3 marks) State the probability distribution of rt and its limit for large t.
(iii) (4 marks) Derive in the case s < t, the conditional expectation E[rt |Fs ], where
{Fs : s 0} is the filtration generated by the Brownian motion B.

Question 7 (15 marks)

The price of a stock through time, {Xt : t 0} is thought to be modelled by the following
relationship:
Xt = 1.7Xt1 0.4Xt2 0.3Xt3 + et 0.7et1 + 0.12et2
For this model,
(i) (2 marks) Write the equation in terms of the backward shift operator B in the form
(B)(1 B)d Xt = (B)et ,
where (B) and (B) are polynomials in B.
(ii) (1 mark) Identify the values of p, d and q for which X is an ARIMA(p, d, q) process.
(iii) (2 marks) Explain whether the process {Xt : t 0} is stationary.
(iv) (2 marks) For the value of d from (ii), put Wt = (1 B)d Xt . Explain why the model
can be written in the equivalent form
X
Wt =
i eti
and calculate i for i = 0, 1, 2.
(v) (2 marks) Another representation of the model is
(B)Wt = et
where (B) = 1

i=1

i B i . Calculate i for i = 1, 2.

(vi) (3 marks) Define two vector-valued stochastic processes Y and Z as

Yt = (Xt , Xt1 , Xt2 )T , Zt = (Xt , Xt1 , Xt2 , Xt3 , Xt4 )T
Explain which, if any, of the processes {Xt : t 0}, {Yt : t 0} and {Zt : t 0} has
the Marksov property.
(vii) (3 marks)
Given a set of observations (x1 , x2 , . . . , xn ) from an ARIMA(1, 1, 1) process with unknown parameter values, outline the main steps that need to be taken so that one can
obtain forecasts for future values of the process.

Question 8 (16 marks)

A stochastic process X = {Xt : t = 0, 1, 2, . . .} is defined by the equation
Xt = + Xt1 + et
together with the condition X0 = x0 , where {et : t = 1, 2, . . .} is a sequence of independent
variables, each normally distributed with mean 0, variance 2 .
(i) (3 marks) Find an expression for Xn in terms of x0 and {et : 1 t n}. Hence find
the limit as n of the distribution of Xn , identifying the condition required for
the distribution to converge.
(ii) (2 marks) Explain why the process X is not weakly stationary.
(iii) (3 marks) Suppose that X0 is no longer fixed, but is a random variable, with distribution equal to the limiting distribution found in (i). Show that both the distribution of
Xt and the covariance of Xt+s with Xt are independent of t, and evaluate the correlation
coefficient s = Corr(Xt , Xt+s ).
(iv) (2 marks) Obtain forecasts of Xn+1 and Xn+2 based on observations {x1 , x2 , . . . , xn },
assuming that and are known.
(v) (4 marks) I have a sequence of observations {s1 , s2 , . . . , sn } of the closing price of a
share on n successive days. I intend to use time series analysis, involving the process X
considered above, to predict future prices of the share. For each of the models (a)(d)
indicate whether the process S is I(0), I(1) or neither. Discuss which of the models is
likely to be the most suitable for my intended purpose.
(a) St = Xt
(b) St = Xt + St1
(c) log St = Xt
(d) log St = Xt + log St1
(vi) (2 marks) Give two points that I should bear in mind when deciding whether to base
my investment decisions on my model.
END OF EXAMINATION