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Institute of Actuaries
EXAMINATIONS
10 April 2000 (pm)
Subject 103 Stochastic Modelling
Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
2.
3.
103A2000
Faculty of Actuaries
Institute of Actuaries
[4]
(m( s , t )) j e m ( s,t )
j!
z (x)dx.
t
s
[5]
Z Zn1 + e3,n
where each of X , Y and Z lies in the interval (1, +1) and the random
variables {ei,n : n 1, i = 1, 2, 3} may be assumed to be uncorrelated and to have
mean zero.
State, giving your reasons:
(a)
(b)
(c)
(d)
1032
[5]
(ii)
(i)
1
(1 + x )2
[4]
[3]
[Total 7]
(x > 0)
1
2(1 +x)2
(x R)
[3]
( x + 2 )
2
(x R)
for all x R
2
( + 1). Hence devise a method based on Acceptance
Rejection sampling for generating observations from the Cauchy
distribution.
[4]
[Total 7]
as long as C
1033
(i)
(a)
(b)
(ii)
(a)
(b)
(c)
[6]
(ii)
(iii)
(a)
(b)
(iv)
1034
[4]
Let b be the average gross payout per beneficiary and c the average
gross payout per contributor per period; this means that the nett
payments are b f and c f respectively, where f is the membership fee
per period (assumed to be uniform over members and over time).
(a)
(b)
(ii)
(a)
(b)
(c)
[5]
Suppose that the equations derived in (i) for 1 and 2 are used as the
basis of an estimation procedure: estimates $ 1 and $ 2 are defined to be
the solutions of those equations when is replaced by a suitablydefined sample autocorrelation function r.
Solve these equations.
10
(i)
[3]
[Total 8]
(a)
(b)
[4]
[5]
(iii)
(iv)
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
P[max( Bs + s) > y ] = G
0s t
FG t y IJ + e
H t K
2 y
FG y t IJ ,
H t K
1035
11
Patients arriving at the Accident and Emergency department (state A) wait for
an average of one hour before being classified by a junior doctor as requiring
in-patient treatment (I), out-patient treatment (O) or further investigation (F).
Only one new arrival in ten is classified as an in-patient, five in ten as outpatients.
If needed, further investigation takes an average of 3 hours, after which 50% of
cases are discharged (D), 25% are sent to receive out-patient treatment and
25% admitted as in-patients.
Out-patient treatment takes an average of 2 hours to complete, in-patient
treatment an average of 60 hours. Both result in discharge.
It is suggested that a time-homogeneous Markov process with states A, F, I, O
and D could be used to model the progress of patients through the system,
with the ultimate aim of reducing the average time spent in the hospital.
(i)
(ii)
(iii)
(iv)
(a)
(b)
[4]
Let mi denote the expectation of the time until discharge for a patient
currently in state i.
(a)
mi =
j {i , D}
ij
i
mj
where i = ij .
j
(b)
(v)
State the distribution of the time spent in each state visited according
to this model.
[1]
The average times listed above may be assumed to be the sample mean waiting
times derived from tracking a large sample of patients through the system.
(vi)
1036
(vii)
1037
(b)
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
April 2000
Subject 103 Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
E[Mn+1Fn] = E[ e - l( n +1 )+ gX n +1Fn ]
= e - l(n +1) E[ e g ( X n +Yn +1 )Fn ] = e - l ( n+1) eg X n E[ eg Yn+1Fn ]
= e - l M n E[ e gYn +1 ] = e - l M n ( pe g + (1 - p ) e - g ).
Hence the condition for martingale:
peg + (1 - p)e-g = el .
Multiply by eg and solve quadratic equation in unknown eg:
eg =
e l e 2l - 4 p(1 - p )
.
2p
(ii)
E{E[XY]} = E[X].
E[ XY ] - E[ X ]E[Y ]
,
s X sY
Page 2
HI X
,
IY
a = mX -
rs X
mY
sY
-0
l( t )
l( t )
F -l(t)
G
A(t) = G
GG
H
l( t )
l( t )
- l( t )
l( t )
- l(t )
L.
I
JJ
.
OJ
J
OK
Forward equations:
t s.
t
s
l(u)du) =
Verify that the form of P0j(s, t) given in the question satisfies this equation:
LHS = (jm(s, t)j-1 - m(s, t)j)
RHS = l(t)
m( s, t) j e -m( s ,t )
m( s, t ) j -1 e -m( s,t )
- l( t )
j!
( j - 1)!
e -m( s ,t )
m( s, t),
j ! t
(a)
(b)
Z satisfies the Markov property on its own; X and Y do not, since they
depend on values of Z.
(c)
(d)
X and Y are not cointegrated. Although both are I(1), any linear
combination W =aX + bY satisfies Wn = Wn-1 + qW Zn-1 + e3,n which does not
define a stationary process.
Page 3
(i)
= E[(Bt - Bs)4 + 4(Bt - Bs)3 + 6(Bt - Bs)2 Bs2 + 4(Bt - Bs) Bs Bs3 + Bs4Fs ]
= E[(Bt - Bs)4] + 6Bs2 E[(Bt - Bs)2] + Bs4 ,
where we used the independence of increments property as well as the fact
that moments of odd order of N(0, s2) vanish. Finally
E[ Bt4Fs ] = Bs4 + 6(t - s) Bs2 + 3(t - s)2.
(ii)
From above
E[ Bt4 - 6tBt2Fs ] = Bs4 + 6(t - s) Bs2 + 3(t - s)2 - 6t(t - s + Bs2 )
(i)
u = F1(x) =
x
u
is solved by x = F1-1 ( u ) =
.
1+ x
1-u
Page 4
2q(1 + x ) 2
By symmetry we only need consider x > 0, so we find maxx>0
.
p( q 2 + x 2 )
Differentiating the logarithm of this fraction and setting equal to 0, we get
2x
2
, with solution x = q2. Substituting this value in, we obtain
= 2
1+ x
q + x2
the required value of C.
Let g(x) =
(i)
(a)
(b)
(ii)
(i)
(a)
States:
C: healthy contributor
C : contributor but ill
B1 , B2 , B3 : beneficiary, with index giving duration of illness
(b)
Transition
graph:
0.9
0.1
0.8
0.8
B1
0.8
B2
0.2
0.8
0.2
B3
0.2
C
0.2
Page 5
F 0.9
GG 0.8
GG 0.8
GH 00..88
P=
01
.
0.2
0
0
0
0
0.2
0
0.2
I
0J
J
0J
0.2J
J
0K
0
(ii)
(iii)
(a)
p = pP reads
pc = 0.9pc + 0.8(pc + p1 + p2 + p3)
pc = 0.2p3
p1 = 0.1pc + 0.2pc
p2 = 0.2p1
p3 = 0.2p2 .
Discard first equation and choose pc as working variable:
p3 =
1
pc = 5pc
0.2
p2 =
1
p3 = 5p3 = 25pc
0.2
1
p2 = 5p2 = 125pc
0.2
pc =
1
0.2
p1 pc = 10p1 - 2pc = 1248pc .
01
.
01
.
(b)
Page 6
1
.
1404
Proportion of beneficiaries:
125 + 25 + 5
= 11.04%.
1404
(a)
=f-c
1249
155
-b
.
1404
1404
(i)
1249
155
+b
.
1404
1404
(a)
(b)
(c)
(ii)
We have = 1 = r1 (1 - a 2 ) and a 2 +
= 1 =
10
(i)
F
GH
(a)
I
JK
a1
a12
g0 and g2 = a 2 +
g0 .
1 - a2
1 - a2
r1 (1 - r2 )
,
1 - r12
= 2 =
a 12
= r2 , which are solved by
1 - a 2
r2 - r12
.
1 - r12
Page 7
gt-s(y - x) =
(b)
2p( t - s )
e -( y -x )
/ 2( t -s )
(ii)
FG y - x - m(t - s) IJ .
H
K
s
By Its lemma
d(log St) =
I
JK
F
GH
1
1
1
dSt +
- 2 ( dSt ) 2
2
St
St
= dt + sdBt -
I2
dt.
2
Hence
F
GH
log St = log S0 + m -
s2
2
I t + sB ,
JK
t
and finally
F m - s I t + sB
G 2 JK
S eH
.
2
St =
(iii)
LM F s I t > log b OP
a PQ
MN GH 2 JK
L 1 F b F s I tI OP
= P MB > G log - G m MN s H a H 2 JK JK PQ
F log b - F m - s I t I
GG a GH 2 JK JJ
= 1-G
JJ .
GG
s t
K
H
Page 8
x - ms
, Bt =
s
1
3
year.
LM
MN
F
GH
F
GH
OP
I I
JK JK
PQ
F F m - s I t + log b I
G G 2 JK
aJ
bU G H
JJ .
log V G aW G
s t
JK
GH
0st
F F m - s I t - log b I
GG GH 2 JK
aJ
R 2m - s
J
=G
+ expS
JJ T s
GG
s t
K
H
2
s2 s
b
1
log
s
a
2 s
2
F bI
The second term is the product of G J
H aK
2m - s2
s2
= 1 - G(2.128) = 1 - 0.9833.
11
(i)
F -1
GG 0
GG 0
GH 00
I
JJ
JJ .
J
0K
0.4
01
.
0.5
1
3
1
12
1
- 60
1
12
1
6
1
60
1
2
0
0
0
0
0
0
- 12
0
1
4 1
1
+
= .
10 10 4
5
(ii)
(iii)
(a)
d
pAA ( t ) = -pAA(t), which has solution pAA(t) = e-t.
dt
(b)
Similarly,
d
1
pAF ( t ) = - pAF (t) + 0.4pAA(t), so that
dt
3
d t/3
{e pAF(t)} = 0.4et/3 pAA(t) = 0.4e-2t/3,
dt
giving pAF (t) = e-t/3 0.6(1 - e-2t/3).
Page 9
(a)
The equation arises as follows: when the process arrives in state i the
subsequent holding time has mean l-1
i , after which the process
jumps to a different state, choosing state j with probability pij = sij / li
(independent of the length of the holding time). The total time to
reach state D is therefore the time until the first jump plus the time
from arriving in the new state until hitting D (unless the new state is
D).
(b)
We have mI = 60, mO = 2, mF = 3 +
1
1
60 +
2 = 18.5,
4
4
mA = 1 + 0.1 60 + 0.5 2 + 0.4 18.5 = 15.4 hours.
(v)
(vi)
A simple check on whether the Markov model fits the data is therefore to
verify that the distributions of holding times are at least roughly
exponential, and a simple way of doing that is to compare sample standard
deviations with sample means. More detailed comparisons might be
possible, depending on the size of the data set.
(vii)
(a)
Calculations required in the first case would include working out the
expected duration of stay if the change were implemented, which
involves solving the equations in (iv) again. For the second situation,
just replace mO in the original calculation. New parameter values
will need to be guessed. Whichever model comes out better should be
compared with the initial situation, to determine whether the
improvement was worth the additional resources.
(b)
Page 10
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
11 September 2000 (pm)
Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
2.
3.
103S2000
Faculty of Actuaries
Institute of Actuaries
N
e2j
(i)
(ii)
Derive an expression for the expected time until all members are infected,
starting from a single infected individual
[2]
[Total 4]
During a long motorway journey a child amuses himself by noting down, at the
end of each minute, the lane in which the car is travelling. The motorway has
three lanes and the journey lasts N minutes.
(i)
(ii)
Describe one test which could be applied to determine whether the process
possesses the Markov property. [2]
[Total 4]
A standard Ornstein-Uhlenbeck process may be defined as a stationary zeromean Gaussian process {Ut : t R} with autocovariance function given by
Cov(Ut , Us) =
2 t s
e
2
(s, t R).
(i)
(ii)
1032
(i)
(ii)
(iii)
z0
P=
F
G
G
H
I
0 J .
J
0K
(i)
(ii)
Calculate, for each of the following initial conditions, the probability that
the chain will be in state 3 when it is observed at time n = 3 given that:
(iii)
1033
[2]
(a)
(b)
(c)
[4]
How would your answers to (a), (b) and (c) change if the time of the
observation were n = 300 instead of n = 3?
[2]
[Total 8]
The daily closing price of a share is observed every trading day for a year,
yielding a sequence of values {s1 , ..., sn}. A model is required for the purposes of
predicting future variability of the share price. The model suggested is a
Brownian one.
(i)
St = + t + Bt
log(St) = + t + Bt
(iii)
(b)
State one of the tests you could carry out on the data to ascertain
whether the model fits adequately.
[3]
(a)
(b)
1034
[1]
Xt = + 0.7(Xt1 ) + 0.5(Xt2 ) + et
II:
Xt = + et + 0.7et1 + 0.5et2
will be best, but cannot decide which. He has simulated both processes from time
t = 1 to time t = 200, but has not obtained the results he expected, so is seeking
your advice.
(i)
(a)
(b)
(ii)
(iii)
(a)
[1]
Derive the lag-1 and lag-2 autocorrelations, 1 and 2, of a secondorder autoregressive process
Xt = + 1 (Xt1 ) + 2 (Xt2 ) + et .
(b)
1035
(ii)
(iii)
Let Ot denote the total amount of time spent in state 0 up until time t,
e ( + )t .
+
+ +
[3]
1 if X s = 0
I sds , where Is =
. Derive,
0 if X s 0
using the result in part (ii), an expression for E[OtX(0) = 0], the expected
occupation time in state 0 by time t for the two-state continuous-time
Markov chain starting in state 0.
[2]
which may be expressed as Ot =
z0
(iv)
Write down the expected occupation time in state 1 by time t for the twostate continuous-time Markov chain starting in state 0.
[1]
(v)
(b)
(c)
Suppose that the evolution of the price of an asset follows the lognormal model
log(St) = Yt = y + t + Bt where Bt denotes the standard Brownian motion and
is a negative drift. The asset will be liquidated at the stopping time
T = inf{t : Yt = a} when its value reduces to ea, where a is some number less than
y. Consider now the exponential Vt = exp(uYt c(u)t).
(i)
[3]
(ii)
[3]
(iii)
1036
10
Consider a survival model with two states alive (A) and dead (D), with timedependent transition rate from A to D equal to (t) = t. The time parameter, t,
represents the age of the individual under consideration.
(i)
(ii)
[2]
z0
P[X x] dx
1 1 G(s )
g(s )
.
x x3
g( x )
x
(iv)
[5]
A company wishes to test the validity of the above model. They assume
that the true force of mortality from age 70 onwards is of the form
(t) = a + bt and intend to test whether a = 0. The testing method will be
to simulate one sample of size 1000 when a = 0 and another when a 0,
then to see which most resembles the data which the company has
collected.
Explain how to simulate a value from the proposed distribution, for
arbitrary values of a and b.
[5]
[Total 16]
1037
11
Explain whether you would expect to fit a model which included (a) a
trend term, (b) a seasonal effect.
[3]
The values {xt : 1 t n} are the residuals which remain once any trend or
seasonal variations have been removed. An ARIMA(1, 1, 1) model is to be fitted
to the {xt}.
(ii)
(iii)
(a)
(b)
[2]
(iv)
(a)
(b)
(vi)
1038
(a)
(b)
(b)
[3]
[Total 18]
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
September 2000
Subject 103 Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
(i)
This is clearly a Markovian birth process. The state space is {0, 1, ..., N}.
Given that we have m infected and N m healthy individuals, the
number of dangerous pair contacts is m(N m). Thus, the rate
m( N m)
m,m+1 = p
.
P
(ii)
The expected total infection time is the sum of the reciprocal rates
N 1
P
1
.
m
=
1
m( N m)
p
1
1 1
1
=
+
(Since
(i)
Let Nij denote the number of minutes when the car was in lane i at the
start of the minute and in lane j at the end. The estimate of the
transition probability pij is Nij / Ni+ , where Ni+ = j Nij .
(ii)
(i)
(ii)
2 k
2
e , so that the ACF is k = ek and the variance 0 =
.
2
2
2
and
1 2
k = k for k > 0.
The two are seen to match as long as = e and 2 = (1 e2)
Page 2
2
.
2
(i)
(ii)
(iii)
Therefore
1
2
Bs3 dBs =
1
4
Bt4
3 t
2 0
Bs2 ds.
(i)
1 2 1
1
P = 2 0 2 ,
4
3 1 0
(ii)
(a)
P133 =
14
7
=
= 0.21875.
64
32
(b)
2
P23
=
2
1
=
= 0.125.
16
8
(c)
14 3
9 3
8 3
14 14 + 9 20 + 8 17
512
8
P13 +
P23 +
P33 =
=
=
.
31 64
31 64
31
31
31
31
(iii)
8 3 5
1
P =
8 6 2 ,
16
5 6 5
2
29 21 14
1
P =
26 18 20 .
64
32 15 17
3
By time n = 300 the effects of the starting point have worn off. The
answer is therefore indistinguishable from the stationary probability 3 in
all three cases.
It is easily observed that the distribution in (c) is stationary, so that
8
3 =
.
31
(i)
(ii)
(a)
Model II does appear to fit better than model I; the S dataset does
indeed exhibit large variations when it is at a high level, and
smaller ones when low.
However, the fit does not appear all that good, as Brownian
increments are normally distributed, so are seldom as large as
some of the jumps which appear in this dataset.
Page 3
(iii)
(i)
(a)
(b)
(a)
(ii)
Page 4
(a)
(b)
We have 0.7 = 1 = 1 / (1 2)
and 0.5 = 2 = 2 + 12 / (1 2) = 2 + 0.71. Two equations in two
35
1
, 2 =
.
unknowns. Solution: 1 =
51
51
(2 marks for the observation that 1 = 0.7 and 2 = 0 is very close
to giving the right answer, as it gives 2 = 0.49.)
(i)
P0,k(t)k,0
(ii)
[e
P0,0(t)] = e(+)t , solved by P0,0(t) =
+ Ce(+)t, with C
dt
+
being determined by the fact that P0,0(0) = 1.
e.g.
(iii)
E0Ot = E0 t0 Is ds =
=
E0 Is ds =
P0,0(s)ds
t+
(1 e(+)t)
2
+
( + )
(iv)
Since the process must be in state 0 or state 1 at all times, the solution is
t
just t E0 0t =
(1 e(+)t).
+
( + )2
(v)
(a)
and
t
(1 e ( + )t )
2
+
( + )
t+
(1 e ( + )t ) .
2
( + )
+
Page 5
(i)
(b)
The assumptions required are that the rate of becoming ill and
rate of recovery from illness are constant.
(c)
2 2
/ 2 c ( u ))t
= euy.
EMT = M0.
It is frequently used to evaluate the expectation of a function of T, such as
the moment generating function (as in this instance).
(iii)
The equation c(u) = v has two roots u+ , u , one being negative and the
other positive (since v is positive).
Now Vt Ta = eu(v )Yt vt and Yt a for 0 t Ta. If u(v) < 0, then
0 < Vt Ta eu(v )a for all t, so that the technical condition is satisfied; the
same cannot be said if u(v) > 0.
Therefore the positive root is unacceptable and f(y, v) = E y e vTa = eu (v )( y a ) .
Comment: For the record, there were two very slight errors in this question, both
appearing as subscripts. In line 4, first formula: T{ } should have read T{a} , and in part
(iii) line 1: T{u} should have read T{a} . This was taken into account by the markers, and
the examiners ensured that no marks were lost by students because of either small error.
Page 6
10
(i)
PAA (s, t) = e
(ii)
xdx
= e (t
s2 ) / 2
E[Rs] =
e sww
/2
s2 ) / 2
= e sww
/2
. Therefore
dw.
(iii)
/2
e ( s+w )
/2
dw = e s
/2
e x
/2
dx
1 1 G( s )
g( s )
E[ Rs ]
1 1
1
s
1
1
1
3 2.
=
3 3/2
s s
s
1
1
=
= 0.00238 . (year)2.
sE[ Rs ]
420
1
+
0,
s s3
1 4 E[ Rs ]
4E[ Rs ]
24
1 1
1 1
2
3
s
70
s
s
=
=
= [0.00023, 0.00215]
2E[ Rs ]
2sE[ Rs ]
2 6 70
1
we see that must lie in the interval
sE[ Rs ]
[0.00215, 0.00238].
(iv)
Page 7
11
(i)
(ii)
(a)
(b)
(iii)
x n (1) = E(Xn+1xn , ..., x1) = xn + (xn xn1) + E(en+1 + enxn , ..., x1). Now
en+1 has mean 0 and is conventionally supposed independent of everything
that happens before n.
On the other hand, en can be deduced from past data,
e.g. en = xn xn1 (xn1 xn2) en1 , which may be iterated back to get
en in terms of the known x and the known e0.
Thus
x n (1) = xn + (xn xn1) + en .
Similarly,
x n (2) = E(Xn+2Fn) = E(Xn+1 + (Xn+1 xn) + en+2 + en+1Fn )
= (1 + ) x n (1) xn .
We see that Xn+1 x n (1) = en+1 , so that the prediction variance is just
Var(en+1) = 2e .
Page 8
(iv)
(v)
(vi)
Two series {x} and {y} are cointegrated if both are I(1) but there are some
constants a and b such that {ax + by} is stationary.
Two processes are likely to be cointegrated if one drives the other, or if
both are driven by the same underlying process. In the given instance the
suggestion is certainly worth investigating.
Page 9
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
10 April 2001 (pm)
Subject 103 Stochastic Modelling
Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
2.
3.
103A2001
Faculty of Actuaries
Institute of Actuaries
(ii)
[3]
[2]
[Total 5]
Give reasons why tests for the goodness of fit should be based on the inter[1]
arrival times Xi = Ti Ti1 rather than on the arrival times Ti .
(ii)
[2]
(iii)
(i)
(ii)
Suppose the inverse of a time series model with spectral density f() is
1
. Using part (i), state
defined to be the model with spectral density
f ( )
the form of the inverse of a first-order moving average and state the way
in which the inverse of an invertible MA(1) differs from the inverse of a
non-invertible MA(1).
[2]
[Total 7]
103 A20012
(i)
State the expectation and variance of dYt = Yt+h Yt , the increment of the
process Yt over a small interval of size h, conditional on Yt = y.
[2]
(ii)
(iii)
Find, by equating the first and second moments of the increments in (i)
and (ii) above, an expression for the drift (y) of the approximating
diffusion in a form which does not involve the time increment h.
[2]
(iv)
(v)
(i)
[1]
Xt = Xt1 + et + et1 ,
where {et : t = 1, 2, } is a sequence of uncorrelated random variables with
[5]
mean 0, variance 2.
(ii)
103 A20013
A motor insurance company has 80,000 policy holders, paying an average annual
premium of 400. The company receives claims at a rate of 2000 per month, the
sizes of the claims having mean 1,200, standard deviation = 200.
Let S(t) denote the companys total surplus at time t, with S(0) equal to the
initial reserve, set at 20,000,000.
(i)
Calculate the expectation of the total amount paid out in claims in a given
month and the safety loading employed by the company.
[2]
(ii)
(iii)
[2]
(ii)
[4]
(iii)
(a)
(b)
(c)
State, with reasons, whether or not the stock would be a good long
term investment in this case.
[5]
[Total 11]
103 A20014
1 2 2
P=
2
1 2 2
0
0
0
[2]
(ii)
[2]
(iii)
(iv)
(v)
For the value = 0.1, calculate the probability that the companys rating
in the third quarter, X3, is in the default state D:
[2]
(a)
in the case where the companys rating in the first quarter, X1, is
equal to A
(b)
in the case X1 = B
(c)
in the case X1 = C
(d)
in the case X1 = D
103 A20015
[3]
[Total 13]
A continuous-time Markov sickness and death model has four states: H (healthy),
S (sick), T (terminally ill) and D (dead). From a healthy state transitions are
possible to states S and D, each at rate 0.05 per year. A sick person recovers his
health at rate 1.0 per year; other possible transitions are to D and T, each with
rate 0.1 per year. Only one transition is possible from the terminally ill state,
and that is to state D with transition rate 0.4 per year.
(i)
(ii)
(iii)
(iv)
Let dj denote the probability that a life which is currently in state j will
never suffer a terminal illness. By considering the first transition from
1
state H, show that dH = 12 + 12 dS and deduce similarly that dS = 12
+ 56 dH .
Hence evaluate dH and dS.
(v)
10
[2]
[5]
Write down the expected duration of a terminal illness, starting from the
moment of the first transition into state T. Use the result of (iv) to deduce
the expectation of the future time spent terminally ill by an individual
who is currently healthy.
[4]
[Total 15]
A family agrees an expenditure target, Yn , for year n, in such a way that the
annual increase in the expenditure target is proportional to the increase in the
family income over the previous year. The actual expenditure during the year,
Xn , is assumed to be related to the expenditure target, but incorporating an
element of randomness and a factor accounting for the familys propensity to
overspend. The family income, In , is assumed to grow at a constant annual rate,
before randomness is taken into account.
The head of the household believes that the following three equations form an
appropriate representation of the above information:
Yn = Yn1 + (In1 In2)
Xn = (1 + ) Yn + en(1)
In = (1 + ) In1 + en(2)
where {( en(1) , en(2) ) : n = 1, 2, } is a sequence of zero-mean bivariate Normal
random variables and , and are positive parameters (with < 1).
103 A20016
(i)
(ii)
[2]
(iii)
(iv)
(v)
[3]
(vi)
(a)
(b)
103 A20017
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
April 2001
Subject 103 Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
(i)
(ii)
(i)
The inter-arrival times are much more suitable because they are
independent.
(ii)
(iii)
(i)
1
2
keik, or equivalent.
2e
(1 + 2 + 2 cos ).
2
2e
1
.
2
2 1 + 2 cos
Clearly from (i) the inverse of the MA(1) is an AR(1), with = and with
a different value of 2e .
The word invertible attached to a MA(1) indicates that the inverse is a
stationary AR(1), whereas a non-invertible MA(1) has as inverse an
AR(1) model which cannot be stationary, such as Xt = 2Xt1 + et.
Page 2
(i)
(ii)
E ( X n +1 X n | X n = y ) = y , Var( X n +1 X n | X n = y ) = 2 .
(iii)
(iv)
(v)
(i)
(ii)
0 =
2
(1 + 2 + 2 ) ,
2
1
1 =
( + ) (1 + )
, 2 = 1.
1 + 2 + 2
= 1.4
0.96 .
Page 3
(i)
C
(400 /12) 80,000 2,000 1,200
=
= 11.11%
2,000 1,200
where denotes the mean arrival rate of claims and the mean claim
size.
(ii)
large, small,
In this case
u =
u
is large, is not particularly small and
(i)
ln( x ) t
t
) , where
1
2
Page 4
tN
2 t
= et e 2 = e
(+ )t .
2
2
(iii)
(ts)+(B(t)B(s))
) = S(s)
(+ )(t s) .
e
2
2
(i)
Transition Graph
1 2
1 2 2
1 2 2
(ii)
(iii)
(iv)
=
=
=
=
A
B
C
D
Page 5
0
0
1
0
Its square is
0.8022 0.169 0.0268 0.002
0
0
1
0
(i)
Transition Graph:
0.05
H
0.1
S
1.0
0.05
0.1
0.4
(ii)
KFE: P (t ) = P(t) A,
0
0.05
0.1 0.05
A=
.
0
0
0.4 0.4
0
0
0
0
(iii)
Page 6
0.1e0.1x dx = e1.
The probability of staying in state H for 10 years is 10
(v)
13
14
1
12
5
6
12 (1 + dS ), implying that dS =
6
7
The Markov property implies that the time spent in state T has
exponential distribution. The rate is 0.4 per year, so the expectation is 2.5
years.
The expected time spent in terminal illness given current health is 2(ever
hit T X0 = H) 2.5 years =
10
2.5
14
(i)
(1 B) Y = B (1 B) I,
with solution Y = BI + const
(ii)
years.
X n 0 (1 + ) X n 1 const en(1)
=
+
+ (2) ,
I n 0 1 + I n 1 0 en
(iv)
( et(2) )2 =
t =2
(I
t =2
(1 + ) It 1 )2 .
Differentiating,
0 = 2
I
t =2
t 1 ( I t
(1 + ) I t 1 ),
Page 7
(v)
(a)
nt=2 It 1 ( I t I t 1 )
tn=2 I t21
First we need to obtain N(0,1) variates Z1 and Z2. The core reading
mentions two methods: either
Z1 =
2 lnU1 sin(2U2),
Z2 =
2 lnU1 cos(2U2)
or
Z1 = V1
2 ln S
,
S
where Vi = 2Ui 1, S =
Z2 = V2
2 ln S
,
S
(vi)
Page 8
1 2 2Z2 .
The revised model still meets the requirements set down at the start of
the problem. It is likely to prove more tractable in that ln I is now a
simple random walk with drift, and is therefore I(1).
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
12 September 2001 (pm)
Subject 103 Stochastic Modelling
Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
2.
3.
103S2001 (13.2.01)
Faculty of Actuaries
Institute of Actuaries
A stochastic interest rate model postulates that the base lending rate in month t,
it , follows the model:
it = 5% + 0.9 (it1 5%) + et ,
where et , e2 , is a sequence of independent Normal random variables with mean
0, variance 2.
(i)
(ii)
(a)
(b)
[4]
(i)
Calculate EB1(t), Var(B1(t)) and Cov{B1(s), B1(t)) for s < t. Deduce that B1
is a standard Brownian motion.
[3]
(ii)
(a)
(b)
103 S20012
(i)
(ii)
(i)
P(t) = 14 e 2t 14 e 6t
(ii)
e 2t e 6 t
1
2
e 2t + 12 e 6t
0
1 23 e 2t + 12 e 6t
1 43 e 2t 14 e 6t .
[5]
Find the time after which a company starting in state A is more likely to
be in state D than in state A.
[2]
[Total 7]
103 S20013
(x > 0).
(i)
(ii)
Explain how, given the value X generated in (i), you would use a sequence
U1 , U2 , of uniform pseudo-random variables to simulate the number of
claims made in two six-month periods by a provisional driver with mean
claim rate X per year.
[4]
(iii)
n
The evolution of a stock price is modelled as a discrete time process Sn = i=
1 Xi ,
(ii)
Assume that p = q =
(iii)
1
2
(a)
(b)
[5]
103 S20014
Determine expressions for the probabilities P{Tu > t}, P{Td > t} and P{T > t}
[2]
(ii)
[2]
(iii)
Show, by evaluating P{T > t and I = 1}, that I and T are independent
random variables.
[3]
(iv)
Calculate the expectation and variance of the interest rate at time t given
the current rate r(0).
Hint: r(t) = r(0) + ju Nu(t) + jd Nd(t).
(v)
103 S20015
[2]
[3]
[Total 12]
A company keeps records of quarterly sales figures, {St : t = 1, 2, n} for the most
recent n quarters. It wishes to analyse the records with the aim of predicting the
sales figures in the near future.
The model suggested by the company is:
log St = + t + Q(t) + Xt ,
where {Xt : t = 1, 2, , n} is a stationary time series, Q(t) takes the value 1, 2, 3 or
4 depending on whether the tth quarter is the first, second, third or fourth
quarter of the financial year, and 1 + 2 + 3 + 4 = 0.
(i)
Explain why the company has suggested a linear model for log St rather
than a linear model for St .
[1]
(ii)
(iii)
Derive a linear filter Yt = +k2= 2 ak log St+k which has the property that the
filtered series {Yt} does not depend on {q : 1 q 4}.
(iv)
[3]
(a)
(b)
[4]
[Total 12]
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)
(b)
(c)
Show that
rt = b + (r0 b) eat +
103 S20016
t
0
e a ( s t ) dBs
[5]
(ii)
(iii)
10
[4]
[3]
[Total 12]
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):
P[Yn+1 = 0Y1 = 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 =
Y .
j
j =1
(i)
(ii)
Draw the transition graph of the Markov chain X and write down its
transition matrix.
(iii)
(iv)
(v)
[4]
[4]
[2]
Suppose you are provided with full claims records for a number of a
companys policy holders.
(a)
(b)
103 S20017
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
September 2001
Subject 103 Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
(i)
(a)
(b)
The RHS has expectation 0.9t 3%, since each eu has expectation
zero, and has variance s2(1 + 0.92 + 0.94 + + 0.92t-2) = s2
(ii)
(1 - 0.92 t )
.
0.19
(i
t =2
- 5% - 0.9(it -1 - 5%))2 .
(i)
EB1(t) = tEB(t-1) = 0;
Var B1(t) = t2 Var B(t-1) = t;
Cov (B1(s), B1(t)) = stCov (B(s-1), B(t-1)) = stt-1 = s for s < t.
These are identical to the corresponding quantities for B.
(ii)
(a)
1 c
1
P[B(t) < ct for all t 1] = P B < for all 1
u
u u
Page 2
(i)
4
7
g0 and g2 =
f1 = r1 =
4
7
, f2 =
2
35
g0 , implying that r1 =
r2 - r12
1 - r12
4
7
and r2 =
(i)
The generator is
0
-4 a 4a
A= a
-4a 3a = a
0
0
0
d
dt
= -0.4.
(ii)
2
35
-4 4 0
1 -4 3
0
0 0
Pt = Pt A.
0
0
= -a
e -2at + 32 ae -6 at
2
=
(ii)
d
dt
3a -2a t
e
+ 23 ae -6 at
2
Pt
3e -2 at - 3e -6 at
3 -2 at
e
+ 32 e -6 at
2
t t implies
3 -2at
1
e
= e -2at .
2
2
Hence,
t=
log 2
.
2a
Page 3
(i)
(ii)
(iii)
(i)
Let A = {TK < T0}, U = {S1 - S0 = 1}, D = {S1 - S0 = -1}. Conditioning after
one step, we find:
pk = P[AS0 = k] = pP[AS0 = k U] + qP[AS0 = k D] = p pk+1 + q pk-1 .
(Together with pK = 1, p0 = 0 this could be used to solve pk )
(ii)
(a)
(b)
Page 4
k
.
K
qk - 1
qK - 1
(i)
P{Tu > t} = e -lut , P{Td > t} = e -ldt , P{T > t} = P{Tu > t} P{Td > t} = e -( lu +ld )t
(ii)
(iii)
lu
lu + l d
lu
lu + l d
e -( lu +ld )t
(iv)
(v)
(i)
(ii)
Page 5
1
4
1
8
Xt+2 .
( 18 , 14 , 14 , 14 , 18 ) will do.
We have
Yt = m + bt +
1
8
Xt-2 +
1
4
Xt-1 +
1
4
Xt +
1
4
Xt+1 +
Hence
Yt = Yt - Yt-1 = b +
1
8
(i)
Ut
t
0
e as ds + s
= r0 + b(eat - 1) + s
t
0
t
0
e as dBs
e as dBs
Thus
= e-at Ut = b + (r0 - b) e-at + s
rt
(ii)
Page 6
e2a( s -t ) ds = s2
1 - e -2at
.
2a
t
0
e a ( s -t ) dBs .
rt
t
0
e au dBu .
s
0
t
0
e au dBuFs
e au dBu
10
(i)
1 - pe
if j - i = 0,
if j - i = 1.
Transition graph
1-p
1 - pe-l
1 - pe-2l
pe-l
pe-2l
Transition matrix:
p 1- p
-l
-l
pe
1 - pe
0
pe -2l
1 - pe -2l
O
O
0
Page 7
(a)
(b)
(c)
(iv)
No new accident:
(pe-jl)n = pn e-njl
(v)
(a)
(b)
Page 8
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
10 April 2002 (pm)
Subject 103 Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 10 questions, beginning your answer to each question on a separate sheet.
103A2002
Faculty of Actuaries
Institute of Actuaries
St = S0 exp X j ,
j =1
(ii)
[4]
State, with a brief explanation, whether the same answer would be obtained if
[1]
Xj had a non-normal distribution with mean mj, variance s2j .
[Total 5]
An analyst wishes to use a model which is based on Brownian motion, but which does
not become too large and positive for large t. The model proposed is
Xt = Bt e-cBt ,
where Bt is standard Brownian motion, and c is a positive constant.
(i)
[2]
(ii)
[3]
(iii)
State, with a brief explanation, whether the suggested model is appropriate for
a process which is asymptotically stationary.
[1]
[Total 6]
103 A20022
(i)
(ii)
(iii)
[2]
[Total 6]
Determine the range of values of a for which the process Y can be stationary.
[3]
(ii)
103 A20023
[6]
[Total 9]
Ratio
1.100
1.000
0.900
0.800
29
27
25
23
21
19
17
15
13
11
0.700
Year, t
Figure 1b
Autocorrelation Function for Ratio
Autocorrelation, r k
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
Lag, k
(i)
Explain which feature of the Figures indicates that differencing is not required
in order to obtain a stationary series.
[1]
(ii)
On the basis of the sample ACF, rk , the companys analyst decides to fit a
first-order autoregressive model to the data. State, with reasons, whether you
consider this to be a reasonable decision and indicate what additional plot you
would require in order to make a firmer recommendation.
[3]
103 A20024
(iii)
The model is fitted and the residuals calculated. The sample ACF of the
residuals is shown in Figure 1c. State what conclusions you would draw from
the plot.
[1]
Figure 1c
Autocorrelation Function for Residuals
Autocorrelation, r k
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
Lag, k
(iv)
(a)
Derive forecasts x30 (1) and x30 (2) for the next two values in the
series.
(b)
[4]
[Total 9]
T A: 5l
T P: 2l
T D: a
P D: 2a
(i)
(ii)
Calculate the probability that, having started in state A, the process has visited
neither T nor P by time t.
[3]
(iii)
(iv)
Solve the equation for pPD(t), the probability that a policyholder, initially
permanently disabled, is dead by t.
[2]
[Total 9]
103 A20025
[2]
(i)
(ii)
(a)
Explain how the above can be used to simulate a path of the Poisson
process with intensity l = 4.
(b)
[4]
(iii)
(iv)
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.
[2]
[Total 10]
A company is studying the health records of its longest serving employee in order to
improve its provision for health insurance. Let X(t) = H if the employee is healthy at
time t, X(t) = S otherwise. The available information includes the value of X(t) for all
0 t T.
(i)
(ii)
103 A20026
(a)
(b)
Write down estimates for the parameters s and r of the model in terms
of quantities which may be derived from the available data.
(c)
Indicate one test which could be used to determine whether the data
support the assumption that the Markov jump process model is
suitable.
[4]
(iii)
103 A20027
Having fitted the model the company discovers that the observed distribution
of holding times in state H does not fit the predictions of the timehomogeneous Markov model; in particular, the mean holding time in state H
between visits to state S appears to be decreasing with t.
(a)
(b)
Explain why the original model could still be used if the company is
large and has a roughly constant age profile.
[4]
[Total 11]
A motor insurer operates a no claims discount system that has five levels. The
percentage of the basic premium paid by the insured in each level is as follows:
Level
% premium charged
5
4
3
2
1
100
90
80
70
60
Insured motorists move between levels depending on the number of claims in the
previous year. For each policyholder, the number of claims per year follows a
Poisson distribution with mean 0.25.
For those in Levels 2, 3, 4 and 5 at the start of the previous year:
if no claims are made during the previous year, the insured moves down one
level (e.g. from Level 4 to Level 3)
if one claim is made during the previous year, the insured moves up one level
(except those in Level 5 at the start of the previous year, who will remain in
Level 5)
if two claims are made during the previous year, the insured moves up two
levels (except those in Level 5 at the start of the previous year, who will
remain in Level 5 and those in Level 4, who will move to Level 5)
if three or more claims are made during the previous year, the insured moves
to Level 5
For those in Level 1 at the start of the start of the previous year, a no claims discount
protection policy applies whereby they remain in Level 1 if they make one claim. If
they make two claims, they move to Level 2. If they make three or more claims, they
move to Level 5. If they make no claims, they remain in Level 1.
(i)
Determine the transition matrix for the no claims discount system (assuming
that all motorists continue their policies).
[3]
(ii)
A policyholder is in Level 3 for the first year of the policy. Assuming that the
policy is maintained, calculate the probability that at the start of the third year
the policyholder will be (a) in Level 1, (b) in Level 3.
[3]
(iii)
(a)
(b)
(c)
103 A20028
(iv)
103 A20029
The insurer suspects that the model used for its calculations may be too
simplistic. Given annual data listing numbers of claims per policy, broken
down by discount level, state which test would be most appropriate to test the
assumption that the distribution of the number of claims per policy per year is
Poisson with mean 0.25.
[1]
[Total 15]
10
(i)
State the Lvy decomposition theorem which describes the constituent parts of
a Lvy process.
[3]
(ii)
(a)
(b)
State the optional stopping theorem and use it to prove that the
probability that the Brownian motion Bt ever hits the line a + bt is
e-2ab.
(iii)
[6]
(iv)
(v)
[2]
St* = s0 + mt + sBt,
where Bt is a standard Brownian motion, as an approximation to the surplus
process St.
(a)
(b)
(c)
Write down the probability that the approximating process S* ever hits
0 assuming that c > kl.
(d)
103 A200210
Faculty of Actuaries
Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
K Forman
Chairman of the Board of Examiners
11 June 2002
Faculty of Actuaries
Institute of Actuaries
(i)
Yk is a martingale, and the values Y1, , Yk are determined by X1, .., Xk, so
E[Yk+1X1, X2, , Xk] = E[Yk+1Y1, Y2, , Yk] = Yk.
Now
k +1
j =1
k
j =1
Y
= a k +1.E e X k +1 . k
a
k
We therefore require
a k +1 =
(ii)
ak
= a k exp -m k +1 - s2k +1
2
E e X k +1
(i)
d
(be - cb ) = (1 - cb)e-cb = 0 when b = 1/c.
db
d2
2
db
b = 1/c. This is negative, so X is indeed maximised at b = 1/c, giving a
maximum value of e-1/c.
(ii)
f
f
2 f
df ( X t , t ) = ( X t , t )dt + ( X t , t )dX t + 2 ( X t , t )(dX t ) 2
t
x
x
2
are OK, with (dX t ) = dt.
Page 2
d2
db
(iii)
(i)
A linear trend means that the line of best fit to the data plotted against time
would have a non-zero slope or that there is evidence from the observations
that there is an underlying tendency for the values to increase or decrease with
time at a constant rate.
Seasonal variation is another deterministic component of the mean which
causes E(Xt) to depend on the remainder when t is divided by the period, d; to
spot it from the data, look for recurring patterns in the data or check the
sample ACF.
(ii)
Either use moving averages: set Yt = (Xt + Xt-1), which has had the seasonal
variation smoothed out.
Or use seasonal differencing: set Yt = 2 X t = X t - X t -2 (from the BoxJenkins armoury)
Or use any linear filter Yt = a j X t - j as long as
j
a = a
j
even j
(any such
odd j
filter does answer the question, though it may look very strange)
Or method of seasonal means: estimate a mean for the even-numbered
observations and another for the odd-numbered ones, then subtract these from
the corresponding observations to obtain a set of residuals, which can then be
analysed.
(iii)
Page 3
(i)
1
1 2 , so we require that
a
2 +1
> 1 and
a
2 -1
> 1 , in
a
Yt = -2Yt-1 + 2Yt-2 + Zt
Cov[Yt,Yt] = 0 = -21 + 22 + 2
(1)
Cov[Yt,Yt-1] = 1 = -20 + 21
(2)
Cov[Yt,Yt-2] = 2 = -21 + 20
(3)
From (2); 1 = -
2ag 0
(4)
1- a2
2ag 0
1- a2
5a 2 - a 4
+ 20 = g 0 .
1 - a 2
(5)
0 =
( )
)(1 - 6a + a )
s2 1 - a 2
1+ a2
substitute for 0 from (6) into (4) and (5) to find 1 and 2
1 =
-2as2
(1+ a )(1 - 6a
2
Page 4
+ a4
(5a - a ) .s
=
(1 + a )(1 - 6a + a )
2
and
(6)
Generally well answered, although the exact range of permitted values for a
in (i) caused difficulties.
(i)
If r1, r2, r3, were all close to 1, that would indicate a need for differencing.
That is not the case here.
(ii)
(iii)
There is a fairly significant departure from a white noise process. The model
does not appear to fit.
(iv)
(a)
(b)
(i)
The generator is
-a - 4l
l
a
3l
-a - 7l 2l
a
5l
.
0
-2a 2a
0
0
0
0
0
Page 5
(ii)
The required event is that either no jump out of A has taken place by t or that a
jump to D has taken place. This has probability
e-(a+4l)t + (1 - e-(a+4l)t)
(iii)
a
.
a + 4l
(iv)
Well done, on the whole. Where there were difficulties they may have been
due to practising more with the time-inhomogeneous version of the equation
rather than the time-homogeneous one.
(i)
Either P(X > x) = P(U < e-4x) = e-4x, so that fX(x) = 4e-4x,
Or probability distribution function F(x) = 1 - e-lx has inverse
1
F-1(y) = - log(1 -y). Hence the inversion method reads:
l
(1)
Generate y from U(0, 1).
1
(2)
Return x = - log(1 - y).
l
1
1
- log y is as good as - log(1 - y) here, since 1 - Y is also U(0, 1).
l
l
(ii)
(a)
xt = 0 if t < t1,
xt = j if tj t < tj+1.
(b)
(iii)
Page 6
(2)
(iv)
The method in (ii) requires an average of four uniform r.v.s per Poisson r.v.;
the method in (iii) requires only one. Since the distribution function needs to
be calculated only once, (iii) should be much more efficient.
Very poorly answered, considering that it deals only with simulating standard
exponential and Poisson random variables. Even the inverse distribution
function method was largely misunderstood. There must be the suspicion that
many candidates are not getting as far as Unit 7 in the Core Reading.
(i)
First choose a class of model which might be supposed, for physical reasons,
to provide a reasonable fit to the data. Identify the parameters of the model.
Next estimate the values of the parameters from the data.
See if the observed data match the pattern which would be expected if the
model were accurate and if the parameters had the values given by their
estimates. If not, the model should be revised.
(ii)
(a)
(b)
The time spent in state H before the next visit to S has mean s-1.
Therefore a reasonable estimate for s is the reciprocal of the mean
length of each visit: s = (Number of transitions from H to S)/(Total
time spent in state H up until the last transition from H to S), although
it would be equally valid to use the Maximum Likelihood Estimator,
which is (Number of transitions from H to S)/(Total time spent in
state H).
Similarly for r .
(iii)
(c)
(a)
Page 7
(b)
(i)
Level at start of this year after:
Level at start
of prev yr
0 claims in
previous yr
1 claims in
previous yr
2 claims in
previous yr
3 or more claims
in previous yr
5
4
3
2
1
4
3
2
1
1
5
5
4
3
1
5
5
5
4
2
5
5
5
5
5
For each policyholder, the number of claims in each year has a Poisson (0.25)
distribution. So
P(0 claims)
= e-0.25
= 0.7788
P(1 claim)
= 0.25 e-0.25
e-0.25
= 0.252 .
2
= 0.1947
P(2 claims)
= 0.0243
0
0
0.0022
0.9735 0.0243
0
0.1947 0.0243 0.0022
0.7788
Transition matrix P = 0
0.7788
0
0.1947 0.0265
0
0.7788
0
0.2212
0
0
0
0
0.7788 0.2212
(ii)
Page 8
(0 0 1 0
(0 0 1 0
( 0 0.7788
( 0.6065 0
0)
0) . P =
(0
0 0.1947 0.0265 ) . P
(a)
The required conditions are that the chain is irreducible and aperiodic.
(b)
(c)
( p1
p2
p3
p4
p5 ) P =
( p1
p2
p3
p4
p5 )
(1)
0.0243p1 + 0.7788p3 = p2
(2)
0.1947p2 + 0.7788p4 = p3
(3)
(4)
and
p1 + p2 + p3 + p4 + p5 = 1
(5)
Page 9
10
(i)
(ii)
(a)
(b)
The optional stopping theorem states that, for any martingale Y and
stopping time T adapted to the same filtration, EYT = Y0 if T is bounded
or Y is bounded or YtT is bounded.
The last of these conditions holds in this case.
We conclude that P(B hits a + bt) = P(M hits 1) = E(MT) = M0 = e-2ab.
(iii)
(iv)
Page 10
(v)
(a)
(b)
(c)
s0 m
- t.
s s
From above, the probability that B ever hits the line a + bt is e-2ab.
Therefore the required approximation to the probability of ruin is
ms
(c - k l) s0
exp -2 20 = exp -2
if c > kl.
s
k 2l
(d)
Page 11
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
11 September 2002 (pm)
Subject 103 Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 10 questions, beginning your answer to each question on a separate sheet.
103S2002
Faculty of Actuaries
Institute of Actuaries
Consider the Poisson process Xt defined as a Markov jump process with state space
{0, 1, 2, } and transition probabilities
(lt ) j -i -lt
e
Pij(t) =
( j - i )!
(j i).
(i)
[3]
(ii)
Yt - a Yt -1 = Z t + (1 - a ) Zt -1
where Zt, t = 0, 1, , is a sequence of independent zero-mean variables with
common variance s2 and where |a| < 1.
(i)
(ii)
[2]
[6]
[Total 8]
Consider the accident proneness model in which the cumulative number of accidents
Xt suffered by a driver is a Markovian birth process with linear transition rates given
by
(i + 1)b if j = i + 1
si,j =
otherwise
0
(i)
Denoting by ai(t) the probability that a driver who has had no accidents at
time 0 has had at least i accidents by time t, explain why
ai(t + dt) = ai(t) + (ai-1(t) - ai(t))ibdt + o(dt)
as dt 0 and hence derive a differential equation satisfied by ai(t).
(ii)
[3]
Show that
ai(t) = (1 - e-bt)i
and deduce the value of P[X(t) = i|X(0) = 0].
103 S20022
[4]
(iii)
A colleague suggests that a better model would involve transition rates si,i+1(t)
which are dependent on t as well as on i. Comment on this suggestion.
[1]
(iv)
(i + 1)b
. Comment on the
t
[1]
[Total 9]
An investor believes that the price of gold increases when the volatility of the equities
market is high and decreases when the volatility is low. The investor therefore wishes
to model the price of gold Xt, as an It process defined by dXt = VtdBt + Vt2 dt , where
Bt is standard Brownian motion and Vt is a measure of market volatility calculated
from the equity price information available at time t.
(i)
(ii)
(a)
(b)
(c)
(iii)
[5]
103 S20023
(i)
(ii)
For each of the following observed processes, identify a type of model which
could be used to model the process, stating which features of the process lead
you to make this choice:
(iii)
(a)
(b)
(c)
(a)
(b)
[3]
T 0.5
P 0
D 0
(i)
0.1
0.3
0
0
0.05
0.1
0.8
0
0.1
0.1 .
0.2
Draw the transition graph of the chain and find its stationary probability
distribution.
[3]
(ii)
[2]
(iii)
(iv)
Calculate the probability that a member, initially active, will never draw any
benefit from the scheme.
[2]
[Total 10]
103 S20024
(i)
Describe the three elements of a linear congruential generator, and set out the
recursive relationship used to generate the pseudo-random number sequence.
[3]
(ii)
The first three numbers produced by a linear congruential generator are 0.954,
0.462 and 0.628. Use these to generate three pseudo-random numbers from
the Pareto distribution with a = 2 and l = 1.
[The density of the Pareto distribution is f(x) =
(iii)
ala
(l + x)a+1
( x > 0).]
[4]
where U is uniformly distributed on [0, 1]. Explain how this can be used to
simulate a path of a Markov jump process {Xt: t 0} which has two states,
H (healthy) and S (sick), with transition rates s from H to S and r from S to H.
Assume X0 = H.
[4]
[Total 11]
103 S20025
An analyst is investigating the extent to which the price of a stock at the beginning
and end of a time interval can be used to provide information about its price during
the interval. The model used is
St = S0 + mt + sBt,
where Bt is a standard Brownian motion. The analyst wishes to investigate the
difference between St and the price St which would be predicted given only S0 and
ST, given by
(T - t ) S0 + tST
St =
, 0 t T.
T
[3]
(ii)
[4]
(iii)
(iv)
(i)
St = S0exp(mt + sBt)
might be more suitable than the one used by the analyst and discuss whether
the results of (iii) might have been substantially different if the analyst had
used this model in the first place.
[3]
[Total 12]
103 S20026
(ii)
(a)
(b)
(c)
(iii)
103 S20027
(a)
Evaluate estimates x20 (1) and x20 (2) for x21 and x22.
(b)
(c)
10
The ticket office at a train station has a single ticket machine that is used by travellers
to purchase tickets.
The machine has a tendency to break down, at which point it must be repaired. The
time until breakdown and the time required to effect repairs both follow the
exponential distribution.
Let P1i(t), i = 0, 1, be the probability that at time t (t > 0) there are i ticket machines
working at the ticket office, given that the ticket machine is working at time t = 0.
(i)
s
- s+r t
1 - e ( ) deduce the value of P11(t).
s+r
[3]
(ii)
(iii)
Write down the generator matrix of the Markov jump process Xt which
counts the number of working ticket machines at time t.
(b)
(c)
2rs
2s2
2s2 + 2rs + r2
and p2 (t ) =
r2
2s2 + 2rs + r2
2s2 + 2rs + r2
d
show that
pi (t ) =0 for i = 0, 1, 2.
dt
(d)
103 S20028
[4]
[6]
[Total 13]
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
September 2002
Subject 103 Stochastic Modelling
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
K G Forman
Chairman of the Board of Examiners
12 November 2002
Faculty of Actuaries
Institute of Actuaries
Questions involving straightforward applications of Markov Chains and Time Series were
well answered, and the standard of answers to questions about martingales and Brownian
motion is improving from year to year, but candidates appeared to experience unexpected
difficulties in relation to the questions on Markov jump processes.
(i)
Prove this using the Markov property. (Note that this mark can be earned for
use of the property even if the word Markov is not mentioned.)
If s0 < s1, < sn < s < t, then
P[ X t - Xs = j| X s0 = i0, , X sn = in, Xs = i]
= P[ X t = i + j|Xs = i] =
(l(t - s )) j -l(t - s )
e
,
j!
E[ X t | Fs ] = E [ X t - X s | Fs ] + E[ X s | Fs ]
= E[ X t - X s ] + X s = l(t - s) + X s .
Thus E[ X t - lt | Fs ] = X s - ls.
The key to part (i) was to use the Markov property; only a few candidates managed to do this
part. Part (ii) was generally well answered.
(i)
(ii)
There are a number of possible ways to calculate the gk, and one way which
sidesteps the gk and calculates the rk directly. The solution presented here is
one of the possible answers; other methods were marked on their merits.
g k = Cov [Yt , Yt -k ] .
Rearrange the time series equation to give Yt = aYt -1 + Zt + (1 - a ) Zt -1
Now Cov[Yt, Zt]
Page 2
= 2
and
Therefore
g 0 = Cov [Yt , Yt ] = a.Cov [Yt , Yt -1 ] + Cov [Yt , Z t ] + (1 - a ) .Cov [Yt , Zt -1 ]
= a.g1 + s2 + (1 - a ) .s 2
g 0 = a.g1 + ( 2 - a ) .s2
(1)
g1 = Cov [Yt , Yt -1 ]
(2)
g1 = a. a.g1 + ( 2 - a ) s 2 + (1 - a ) .s 2
( 2 - a ) .a + (1 - a ) .s2 1 + a - a 2 2
g1 =
=
.s
1 - a 2
1- a2
(1 + a - a ) .s
= a.
2
g0
1- a2
2 - a2 2
+ ( 2 - a ) .s 2 =
.s
1 - a 2
For k 2,
g k = Cov [Yt , Yt - k ]
gk
. Therefore
g0
r0 = 1
r1 =
1+ a - a2
2 - a2
r k = a k -1r1
k2
Part (i) was generally well answered, using a variety of different approaches. Candidates
generally made good attempts at part (ii), the main problems occurring being a failure to
correctly specify 0 and algebraic errors in solving the simultaneous equations.
(i)
If the driver is to have had at least i accidents by time t + dt, either there must
have been i accidents by time t or there must have been exactly i - 1 by time t
and another between t and t + dt.
P (exactly i - 1) = P(at least i - 1) - P(at least i ).
Therefore
dai
= ib(ai-1 - ai).
dt
(ii)
Verification:
d
{(1 - e-bt)i}= ibe-bt(1 - e-bt)i-1 .
dt
P0,i(t) = P {}
Ti t} - P{Ti +1 t} = (1 - e-bt)i - (1 - e-bt)i+1 = e-bt(1 - e-bt)i
(iii)
(iv)
The proposed model does address the issue raised in (iii) but leads to a very
high accident rate when t is close to 0, so is unsuitable.
Many candidates attempted part (i), but were unable to give a sufficiently clear description to
convincingly display their understanding and so did not earn full marks. In some cases,
Page 4
candidates did not correctly interpret the definition of ai(t). In part (ii) many candidates tried
to solve the differential equation, where they could instead have simply shown the solution
given to be valid. Candidates generally came up with sensible suggestions for part (iii), but
only a few candidates were able to make suitable comments on part (iv).
(i)
When volatility is high, dXt is strongly upwards; when volatility is low, dXt is
close to zero.
The first of these fits the assumptions, whereas for the second something more
negative would be preferable. (It looks as though the process X has more
opportunity to increase than to decrease.)
(ii)
df(Xt) =
f
f
2 f
dt + (Yt dt + Zt dBt ) + 2 Zt2 dt.
t
x
x
(b) Here
df(Xt) = f ( X t )dX t + f ( X t )(dX t ) 2
= f ( X t )[Yt dBt + Yt2 dt ] + f ( X t )Yt 2 dt
= f ( X t )Yt dBt + Yt2 [ f ( X t ) + f ( X t )]dt.
In this instance, df(Xt) = -2e-2 X t Vt dBt .
(c) This is a martingale by the disappearance of the dt term, as E(dBt | Ft) = 0.
Alternatively,
T
which is a martingale.
(iii)
Page 5
This confirms the initial suggestion that downward movements are too
unlikely in comparison to upward ones.
The question generally showed good attempts, with a variety of different but correct versions
of It's Lemma being given. The only real problem evident here was in part (iv), where many
candidates failed to use the given inequality to prove the point.
(i)
Discrete state space, discrete time: Markov chain, simple random walk,
anything like that;
Discrete state space, continuous time: Poisson process, Markov jump process;
Continuous state space, discrete time: time series, general random walk;
Continuous state space, continuous time: It process, Brownian motion, etc.
(ii)
(iii)
(a)
(b)
Page 6
(i)
(For full credit the probabilities should all be included on the diagram.)
Stationary distribution pA = pT = pP = 0, pD = 1. Derivation not required: the
answer is obvious to anyone who understands.
(ii)
1
= 5.
1 - 0.8
(iii)
(iv)
Page 7
= 0.1 (0.75)n =
n=0
0.1
= 0.4.
1 - 0.75
Most candidates correctly gave the transition graph in part (i), although there were a few
cases where the transition probabilities were not included in the solution. Part (iii) was well
answered. Solutions to (ii) and (iv) were mixed, with perhaps less than a third of students
immediately recognising the required approach and thereby gaining full marks.
(i)
f(x) =
ala
(l + x)a+1
x=
(iii)
1
, so that F(x) = 1 -
3
(1 + x)
1+ x
1
- 1. , so
1 - F ( x)
The structure of a Markov jump process implies that the time until the next
jump has exponential distribution, with rate s if the current state is H, r if S.
The even-numbered inter-jump times will have one distribution, the oddnumbered ones a different one.
Obtain numbers y0, y2, y4, , y2n by the above procedure, being simulated
outcomes of independent random variables Y0, Y2, Y4, , Y2n exponentially
distributed with parameter s. Similarly, obtain y1, y3, , y2n-1 using a
parameter r instead of s.
Page 8
Candidates made reasonable attempts at part (i), although in many cases insufficient detail
was provided to score full marks. Part (ii) was generally well answered, the only problem
here being simple algebraic errors. Part (iii) was not answered well, with candidates on the
whole failing to recognise that the transitions from healthy to sick and from sick to healthy
should be modelled separately and then combined to provide the required process.
(i)
E ( St - S0 ) = mt , Var( St - S0 ) =s2t.
E ( ST - St ) = m (T - t ), Var( ST - St ) = s2(T - t).
Cov(St - S0, ST - St) = 0, because of the independent increment property of
Brownian motion.
(ii)
T - t
t
= Var
( St - S0 ) - ( ST - St )
T
T
t (T - t )s 2
T -t 2 t 2
=
.
s t + T s (T - t ) =
T
T
(iii)
(iv)
Two possible reasons might be that a Brownian motion can become negative,
which a stock price cannot, and that fluctuations in the value of a stock price
are usually proportional to the price. Other reasons could also apply.
Under the revised model ln(St) has the same structure as St in the original
model, so ln(St) will have its greatest variability at T. The result will not
differ greatly from the result above.
Candidates generally gave good answers for part (i). However, answers to part (ii) and (iii)
were disappointing, particularly for part (iii) where the answer can be derived very simply
from general reasoning. Part (iv) in general showed better answers, although many
candidates failed to get full marks because they did not discuss how their response to (iii)
would differ under the new model.
Page 9
(i)
(ii)
(a)
(b)
(c)
(iii)
(a)
(b)
(c)
In part (i) a number of candidates omitted from the list of parameters. Part (ii) (a) showed
some good answers, however in most cases insufficient details was provided to earn full
marks. Part (ii) (c) was very poorly answered, with very few candidates showing that they
understood the concept of backforecasting. In part (iii) most candidates understood what
was generally required, though in some cases there were errors in applying the formulae.
10
(i)
Page 10
d
P10 ( t ) = - r.P10 ( t ) + s.P11 ( t )
dt
(1)
and
P11 ( t + h ) = r.h.P10 ( t ) + (1 - s.h ) .P11 ( t )
d
P11 ( t ) = r.P10 ( t ) - s.P11 ( t )
(2)
dt
[(2) also follows from the fact that P10 ( t ) + P11 ( t ) = 1 .]
(ii)
P10 ( t ) + P11 ( t ) = 1
so from (1)
d
P10 ( t ) + ( s + r ) .P10 ( t ) = s
dt
d ( s+r )t
s+r t
e
P10 ( t ) = s.e( ) + C
dt
P10 ( t ) =
s
s+r t
- s+r t
.e( ) + C.e ( )
s+r
P10 ( t ) =
s
- s+r t
. 1- e ( )
s+r
since P10(0) = 0.
[Alternatively, instead of solving the DE, just verify that the function
proposed as the solution does indeed satisfy the DE and also check that the
value is correct at t = 0.]
Therefore
P11 (t ) = 1 (iii)
(a)
- s+r t
s
r + se ( )
- s+r t
. 1- e ( ) =
.
s+r
s+r
s - (s + r) r
0
-2s
2s
(b)
Page 11
d
p2 ( t ) = r. p1 ( t ) - 2s. p2 ( t )
dt
(c)
(d)
Page 12
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
8 April 2003 (pm)
Subject 103 Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 10 questions, beginning your answer to each question on a separate sheet.
103A2003
Faculty of Actuaries
Institute of Actuaries
4
2
1
5
3
6
During each period under observation, the mouse moves to any adjacent, accessible
compartment with equal probability. Successive moves have the Markov property.
Let Xt be the compartment number that the mouse is in at time t.
(i)
(ii)
(iii)
[2]
[Total 6]
An index of salaries, St, and an index of prices, Pt, are modelled as being related to
each other in the following way:
ln St = qS + a1 ln St -1 + a 2 ln Pt -1 + eS ,t
ln Pt = q P + b1 ln St -1 + b2 ln Pt -1 + eP ,t
where eS,t and eP,t are two independent zero-mean white noise processes, with
variances s12 and s22 respectively, and qS and qP are constants.
(i)
(ii)
[1]
(iii)
(iv)
Suppose the parameters of the model have been estimated. Describe the use of
sensitivity analysis in determining the validity of the model.
[2]
[Total 7]
103 A20032
(i)
Let Yt denote Brownian motion with drift m and variance rate s2, starting at 0.
Write down the expectation E(Yt) and variance Var(Yt) of this process.
[1]
(ii)
t
h
Z
i =1 i
where Z1, Z2, are independent random variables, each with distribution
P[Zi = D] = p, P[Zi = -D] = 1 - p. Calculate the expectation and variance of
Xnh and derive an expression for the expectation and variance of Xt.
[3]
[Notation: x denotes the integer part of x.]
(iii)
(i)
(a)
(b)
f ( x) = qe-qx
(ii)
[2]
e -qx
, x>0
1+ x
103 A20033
(a)
(b)
(i)
Calculate the value of k which gives W(t) the same expectation and
covariance function as B(t).
(b)
(ii)
[5]
[Total 9]
0% discount
25% discount
40% discount
50% discount
(ii)
[2]
(a)
(b)
Write down the transition matrix for the Markov chain {Y (t )}t=1.
(c)
103 A20034
[2]
(ii)
(iii)
A trainee believes that the model is too simplistic. For each of the trainees
suggestions below, comment on whether following the suggestion would be
likely to improve the models predictive power:
(a)
(b)
(c)
sSH and sSD should also depend on the duration of the sickness to date.
[3]
(iv)
(v)
Assume that several years of quarterly claims data are available. Describe a
test to determine whether the model with annually time-varying transition
rates, as in (iii)(b), is a better fit to the data than the model with constant
transition rates.
[2]
[Total 10]
103 A20035
A branch of a bank has three cash dispensers. If at time t a cash dispenser is working,
the probability that it will break down in (t, t + dt) is independent of the state of the
other cash dispensers and is equal to
dt + o(dt).
When a cash dispenser breaks down, repair work begins immediately. The time taken
to repair a broken machine is exponentially distributed with mean 1/. There are
enough repair teams to repair all three cash dispensers at the same time, if necessary.
Define Xt as the number of machines not working at time t.
(i)
(ii)
(a)
If a cash dispenser is working at time 0, prove that the time until its
first breakdown is exponentially distributed with mean 1/.
(b)
(iii)
[1]
[5]
Define Pm(t) as the probability that m machines are not working at time t.
Show that the forward equations for the process X imply that:
P0 (t ) = - 3aP0 (t ) + bP1 (t )
P3(t ) = - 3bP3 (t ) + aP2 (t )
and for m = 1, 2,
Pm (t ) = - ((3 - m)a + mb) Pm (t ) + (4 - m)aPm-1 (t ) + (m + 1)bPm+1 (t ) .
(iv)
[3]
At time 0 all three cash dispensers are working. Show that the forward
equations have a solution
3
Pm (t ) = q(t )m [1 - q(t )]3-m , m = 0,1, 2,3
m
103 A20036
In a simple discrete-time model for the price of a share, the change in price at time t,
Xt, is assumed to be independent of anything that has happened before time t and to
have distribution:
with probability p
1
,
Xt = -1 with probability q
0 with probability r = 1 - p - q
where p, q, r > 0.
Let S0 = m (where m is a positive integer) be the original price of the share,
Sn = S0 +
n
t =1
Yn = ( q / p ) S n
(i)
Show that {Yn : n 1} is a martingale and that for any positive integer n,
E(Yn) = (q/p)m
(ii)
[4]
Let T be the time until the share price reaches either 0 or N for the first time,
where N is an integer greater than m.
(a)
(b)
(iii)
Assuming that p q, calculate the probability that, starting from m, the share
price reaches 0 before it reaches N, i.e. P(ST = 0 S0 = m).
[3]
(iv)
(b)
Show that the expected value of the time until absorption, T, is given
by
E(TS0 = m) =
m ( N - m)
.
2p
[5]
[Total 14]
103 A20037
10
Write the equation in terms of the backward shift operator B in the form
f(B)(1 - B)d Xt = q(B)et,
[3]
(ii)
(iii)
(iv)
For the value of d from (ii), put Wt = (1 - B)dXt. Explain why the model can
be written in the equivalent form
Wt =
yi et -i
[1]
[3]
where p(B) = 1 -
(vi)
i=1 pi Bi .
Calculate pi for i = 1, 2.
[1]
(vii)
103 A20038
Faculty of Actuaries
Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however
given credit for any alternative approach or interpretation which they consider to be
reasonable.
J Curtis
Chairman of the Board of Examiners
3 June 2003
Faculty of Actuaries
Institute of Actuaries
(i)
Transition diagram:
1
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
4
0.5
0.5
(ii)
(a) and (c) are both zero, as it is not possible to return to 1 in an odd number of
steps.
1 1 1
(2)
= p12 p21 + p13 p31 = + = .
For (b): p1,1
4 4 2
(iii)
(a)
Yes every chain with finite state space has a stationary distribution.
(b)
It was possible to read the question as implying the possibility that the mouse could
stay where it was: candidates who did this were still able to obtain full marks for the
question.
Every candidate was able to draw the diagram correctly and most of them correctly
evaluated the required probabilities.
Some candidates were not clear about the distinction between a stationary
distribution and a limiting distribution.
(i)
(ii)
(iii)
ln St a1 a 2 ln St -1 qS eS ,t
.
=
+ +
ln Pt b1 b2 ln Pt -1 qP eP ,t
Page 2
values estimated from data) look similar to what has actually been observed.
For sensitivity analysis you check that this still works when the parameter
values used for the simulation are a little bit different from the estimates. The
purpose is to guard against the possibility that you have by chance used
parameter values with untypical properties.
Parts (i) and (ii) were done quite well. In part (i) a lot of people concentrated just on
the logs or just on the differences rather than both. In part (ii) quite a few people gave
answers such as "both are linked to inflation" rather than explaining why, or only
considered one way (eg why should salaries be related to prices, but not the other
way around).
Most people got part (iii). In part (iv) most people mentioned varying the parameters
slightly, but not many conveyed the idea of then studying the simulated output of the
model and assessing whether it still looked similar to real life.
(i)
(ii)
(iii)
(a)
(b)
1 mh 2
2
2 2
1 + , D = s h + m h .
2
D
This applies only when 0 |h| < m-1. Small values of h should be used
because the random walk model converges to Brownian motion /
diffusion as h 0.
Parts (i) and (ii) were well answered maybe half the people successfully equated
the random walk moments with the Brownian motion ones although many
candidates failed to see the derivation of the conditions on p and D through to
completion.
The biggest problem was the last part: "h small" is on the whole a bit too vague to get
the full credit.
(i)
Page 3
(a)
(b)
1.
2.
Most candidates did well here, although a few people inverted the density function
instead of the distribution function.
Some experienced real difficulty in providing a clear statement of the algorithm for
Acceptance-Rejection method. A lot of people answered this part in abstract without
realising that they should use the density from part (i) as the base density, and hence
didn't get the marks for calculating C.
(i)
(a)
(b)
Page 4
*
(ii)
) (
E (e
E (e
E e 2 B (t ) | Fs = E e2[ B (t )- B ( s )]e 2 B ( s ) | Fs
= e2 B ( s )
2[ B (t )- B ( s )]
= e2 B ( s )
2[ B (t )- B ( s )]
| Fs
The increment B(t) B(s) has the normal distribution with mean 0 and
variance t - s, so the expectation of e2[B(t) B(s)] is equal to
M(2) = exp(2(t - s)), where M() is the moment generating function of the
N(0, t - s) distribution.
It follows that
E e 2 B (t )-2t | Fs = e2 B ( s )-2 s
and therefore e2[B(t)- t] is a martingale.
For part (i), in (a) many candidates just checked variance rather than the covariance,
but got 1/16 correct. Not so many people got part (b) generally people assumed
that (a) implied (b), rather than considering other properties of Brownian motion
Most candidates fared well on part (ii), identifying where necessary the mgf of a
normal random variable to successfully demonstrate the given process is a
martingale.
Page 5
(i)
(ii)
(a)
(b)
(c)
1
0.2
0.2
0
0
0.2
2
0.8
0
0.2
0
0
3a
0
0.8
0
0
0
4
0
0
0.8
0.8
0.8
3b
0
0
0
0.2
0
We have
p1 = 0.2p1 + 0.2p2 + 0.2p3b
p2 = 0.8p1 + 0.2p3a
p3a = 0.2p3b + 0.2p3a
p3b = 0.2p4
p1 = 0.25p2 + 0.25p3b
p2 = 0.25(p3a + p3b)
p3a = 0.25p3b
1
(21, 20, 16, 320, 64).
441
(i)
-r - n n .
r
0
0
0
(ii)
Page 6
h=
(iii)
1
s
+
s,
s+m s+m
s=
1
r
+
h .]
r+n r+n
(a)
(b)
(c)
(iv)
(v)
This can be regarded a Time Series problem: we seek a test for the existence
of seasonal variation. One suggestion could be to find the best-fitting model
without seasonal variation and the best-fitting with seasonal variation, then to
compare the values of the Akaike Information Criterion.
Alternatively, if the number of policyholders is roughly constant from year to
year, one could use one-way Analysis of Variance to determine whether
Season has a significant effect on claims. If the number of policyholders
varies greatly from year to year, a two-way ANOVA with Year and Season as
explanatory variables could be fitted.
Page 7
(i)
(ii)
(a)
Let T be the time taken for a cash dispenser to break down. From the
question:
P (T ( t , t + dt ) | T > t ) = a dt + o(dt )
or in other words
P (T ( t , t + dt )
P (T > t )
) = adt + o(dt )
1 - F (t )
= adt + o(dt )
and letting dt 0,
F (t )
1 - F (t )
=a
P(no breakdowns by time t) = (e-at)3 = e-3at. Thus the time until the
first breakdown is exponentially distributed with parameter 3a.
Page 8
3
= q(t )m-1 (1 - q(t )) 2-m -[mb + (3 - m)a ]q(1 - q) + ma (1 - q) 2 + (3 - m)bq2
m
3
= q(t )m-1 (1 - q(t )) 2-m (m - 3q) {a (1 - q) - bq}
m
Thus the LHS and RHS are equal as long as q' (t ) = a - (a + b)q(t ) .
Almost everyone got part (i). In part (ii), stating the time until first breakdown is
exponential in (a) is not sufficient: it was necessary to derive this from first principles.
Similarly, a reasonable number got the answer to (b) without deriving it properly.
The most successful strategy for part (iii) was writing the generator matrix and
getting the equations from there.
Only the exceptional candidate attempted (iv); the algebra was tough, but did not
involve any tricks.
(i)
Page 9
= (q / p) Sn ( p(q / p ) + q (q / p ) -1 + (1 - p - q )) = Yn ,
which shows that Yn is a martingale.
By taking expectations, we obtain that E(Yn+1) = E(Yn), and this in turn implies
that E(Yn) = E(Y0) = (q/p)m.
(ii)
(a)
(b)
(iii)
m
N
0
q N
q
q
q
= E (YT ) = P( ST = N ) + P( ST = 0) = 1 - 1 - P( ST = N ).
p
p
p
p
Thus P( ST = N ) =
(iv)
(a)
1 - (q / p) m
1 - (q / p) N
so that P( ST = 0) =
(q / p)m - (q / p) N
1 - (q / p) N
We have
E(Zn+1X1, X2, , Xn) = E ( Sn2 + 2Sn X n+1 + X n2+1 - 2(n + 1) pX1 , X 2 ,..., X n )
= Sn2 - 2(n + 1) p + 2Sn E ( X n +1) + E ( X n2+1 ).
The conditions of the optional stopping theorem are not satisfied, since
Sn2 - 2np is not bounded below for 0 n T. But we can work with a
truncated stopping time TK = min(T, K), for which the conditions of the
OST are satisfied, then let K .
Applying the optional stopping theorem we get
E(ZT) = E(Z0) = m2.
Page 10
10
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Page 11
(vii)
First transform the data, so that the differenced observations yt = (1 - B)xt may
be thought of as realisations of a stationary ARIMA(1, 1) model.
Estimate the parameters of the model (by Maximum Likelihood or Method of
Moments) and obtain forecasts for future values of y.
Transform these back to obtain forecasts for the x values.
Part (i) was done very well; of people with the wrong answer, most stopped after
taking out one (1-B) factor rather than trying for the 2nd. (ii) and (iii) were also well
answered, following on from (i).
In (iv) there were difficulties with the expansion of the denominator, meaning that few
candidates did well. Similar problems were encountered with part (v).
For the verification or otherwise of the Markov property in (vi) it would have helped
to write out {Yt} and {Zt} explicitly in terms of lagged terms.
Most candidates who attempted (vii) got at least part of the method, but few wrote
down all the main steps in the correct sequence.
Page 12
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
15 September 2003 (pm)
Subject 103 Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 11 questions, beginning your answer to each question on a separate sheet.
103S2003
Faculty of Actuaries
Institute of Actuaries
A wheel is divided into 37 equal sections, labelled from 0 to 36. A ball is rolled
repeatedly around the wheel, landing in sections X1, X2, Let Mn be the highest
outcome achieved from the first n rolls, i.e. Mn = max1in Xi.
(i)
[1]
(ii)
[2]
(iii)
[1]
(iv)
(i)
Calculate the covariance between the values X(t), X(t + s) taken by a Poisson
process X(t) with constant rate l at the two times t and t + s, where s > 0. [2]
(ii)
Calculate the covariance between the values B(t), B(t + s) taken by a standard
Brownian motion B(t) at the two times t and t + s, where s > 0.
[1]
(iii)
[1]
[Total 5]
[4]
[Total 7]
(a)
(b)
(ii)
103 S20032
[3]
[Total 7]
Assume that the yield rate Yt of a certain stock may either take a high constant value
yu or a low constant value yd, during alternating random exponential periods with
respective intensities lu, ld.
(i)
Write down Kolmogorovs forward equation for the probability Pu,u(t) that Y
is in state yu at time t, given that it starts in state yu.
[1]
(ii)
Show that
Pu,u =
(iii)
ld
lu
e- ( lu +ld )t .
+
lu + l d lu + l d
Let Ut denote the total amount of time spent in state yu up until time t. Derive
and expression for E[UtY(0) = yu], the expected occupation time in state yu
by time t for the two-state continuous-time Markov chain starting in state yu.
Hint: Note that Ut =
result.
(iv)
[2]
1 if Ys = yu
and use the previous
I
ds
,
where
I
=
s
s
0
0 if Ys yu
[2]
t
Derive an expression for the expected total yield Xt of the stock by time t.
Hint: Xt = yuUt + yd(t - Ut).
[2]
[Total 7]
Let X1, X2, X3, be independent, identically distributed random variables with
P(X1 = +1) = p > and P(X1 = -1) = 1 - p < . Let S0 = 0, Sn = X1 + X2 + + Xn
for n 1 be the associated random walk.
(i)
[1]
(ii)
[2]
(iii)
Let T1 be the first time that Sn hits 1, i.e. T1 = min{n : Sn = 1}. State the
conditions on c and on q(c) under which it is valid to use the Optional
Stopping Theorem to evaluate E ( M T1 ) .
[2]
(iv)
103 S20033
[3]
[Total 8]
(i)
1
(et + et-1 + + et-m),
m +1
[4]
Explain whether or not the process is invertible in the case where m = 2. [4]
[Total 8]
The data set plotted in Figure 1a represents the number of applications, xt, for travel
insurance received by an insurance companys web site, measured for a total of 60
consecutive months. Figure 1b displays the logarithm of the same data set, yt = ln(xt).
(i)
A statistician decides, on the basis of these plots, to fit a linear time series
model to yt rather than to xt. State, giving reasons for your answer, whether
you agree with this decision.
[2]
(ii)
Explain what is meant by the terms seasonal variation and linear trend.
Outline one method of compensating for seasonal variation and linear trend in
a data set which exhibits both.
[3]
(iii)
The data set zt is a seasonally adjusted, detrended version of yt. Figures 2a and
2b below display respectively the sample autocorrelation function and sample
partial autocorrelation function of zt.
(iv)
103 S20034
(a)
(b)
Explain how to produce a forecast x60 (1) for the value of x61 given the BoxJenkins forecast z60 (1) for the value of z61.
[2]
[Total 10]
10
20
30
40
50
60
10
20
Month, t
30
40
50
Month, t
Figure 1a
Figure 1b
Autocorrelation function of z t
0.6
ACF, r k
0.4
0.2
0
-0.2 0
10
11
-0.4
-0.6
Lag, k
Figure 2a
PACF
Log(Volume), y t = ln(x t )
0.3
0.2
0.1
0
-0.1 0
-0.2
-0.3
-0.4
-0.5
10
11
Lag, k
Figure 2b
103 S20035
60
A no-claims discount scheme has six classes of discount numbered from 0 (no
discount) to 5 (maximum discount). A claim-free year results in a move to the next
higher discount status (or in the retention of the maximum discount status); similarly a
year with one or more claims results in a move to the next lower discount class (or in
the retention of the no-discount status).
(i)
(ii)
(a)
(b)
(c)
(iii)
Explain how this analysis can be used to help the insurance company to set its
premium levels.
[2]
[Total 10]
where m(x), the force of mortality, is given by m(x) = a + bx, and a and b are positive
parameters whose values are known.
(i)
(ii)
(iii)
103 S20036
[5]
Describe a method for doing this which does not involve 10 repetitions
of the method in (i).
(b)
Explain the main advantages of the method in (a) when a large number
of simulated copies of the random variable Y are needed.
[4]
The trainee is asked to investigate the effect of a reduction in the mortality rate
by repeating the whole simulation for different values of a and b. State with
reasons whether the trainee should use the same sequence of pseudo-random
numbers as before or whether a different sequence would be preferable.
[1]
[Total 10]
10
(i)
(ii)
[5]
(iii)
(iv)
Verify that the stationary distribution of the diffusion process in (i) is Normal,
and identify the mean and variance.
[2]
(v)
When the equation in (iii) is applied to the geometric Brownian motion, the
general solution is found to be
A
p ( x) = + Bx k ,
x
2
where k = -2 + 2m/s and A and B are arbitrary constants. Show that there is
no probability density function p(x) which solves the equation in (iii) in the
case of the geometric Brownian motion and explain the implication of this. [2]
[Total 13]
103 S20037
11
A continuous-time process with three states is observed from time 0 up until the time
of the 20th transition. The results may be summarised as follows:
State, i
No. of visits
to state i
Minutes spent
in state i
1
2
3
8
4
8
48
160
240
No. of transitions
from state i to:
State 1 State 2 State 3
1
7
3
1
5
3
-
(i)
Describe the stages of model fitting and model verification in the modelling
process.
[2]
(ii)
Suppose that a Markov jump process model is to be fitted to the data set
above. List all the parameters of the model and discuss the assumptions made
when such a model is fitted to a data set.
[4]
(iii)
Estimate the parameters of the model in (ii) above and write down the
estimated generator matrix.
[4]
(iv)
Suggest one test which could be applied as part of the model verification
process. State the null hypothesis, H0, identify the test statistic and name its
distribution under H0.
[2]
(v)
The 20th transition of the observed process takes it into state 1. Use the
estimated parameter values to give point estimates of the times until the 21st
and 22nd transitions.
[3]
[Total 15]
103 S20038
Faculty of Actuaries
Institute of Actuaries
Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
September 2003
Subject 103
Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
September 2003
Examiners Report
(i)
Suppose that Mn = i. Then the value of Mn+1 depends entirely on the outcome
of the next spin of the roulette wheel (this being independent of Mn) and the
value of Mn. Hence Mn is a Markov chain.
(ii)
Let Xn be the winning number from the nth spin of the roulette wheel. Then
P(Xn = i) = 1/37 for all i = 0, 1, 2, .,36.
If j > i then P(Mn+1 = j | Mn = i) = P(Xn+1 = j) = 1/37;
If j < i then P(Mn+1 = j | Mn = i) = 0;
If j = i then P(Mn+1 = j | Mn = i) = P(Xn+1 i) = (i + 1)/37.
1
i.e. pij =
37
(i 1)
37
if
if
if
(iii)
(iv)
The general reasoning type answers required for parts (i), (iii) and (iv) were quite well done in
general. There were some difficulties with part (ii) However candidates fared less well on part (ii),
and in many cases candidates struggling on part (ii) then failed to attempt the later parts.
(i)
The Poisson process and the standard Brownian motion both possess the
independent increments property.
Cov(X(t), X(t + s)) = Cov(X(t), X(t)) + Cov(X(t), X(t + s)
the independent increments property.
X(t)) = t + 0, by
(ii)
B(t) = t.
(iii)
(a)
(b)
Page 3
(c)
September 2003
Examiners Report
(i)
(a)
1z
2z
=0
(b)
2
1
2
1
2.
2
1
2 1
2 1 and
which is equivalent to
2
1
implying that
1.5.
z =
2
1
(2
2
1
2
1)
=2
= H 2 ( ) f e ( ),
2
where H1 is the transfer function associated with (1
1B
2B ), H2 the
transfer function associated with (1 + B), fX( ) is the spectral density of X
and fe( ) is the spectral density of e.
Page 4
September 2003
Examiners Report
We have
H1( ) = |1
1e
2e
2i |2,
2/(2
).
Therefore
2
fX
=
2
2
1
2
2
2 cos( )
cos
1 2
2 cos
There was good understanding of the ARIMA process, which meant that candidates
successfully derived the quadratic equation in part (i), though some were let down by their
knowledge of complex numbers. Part (ii) was a straightforward application of the transfer
function: the fact that marks were on average slightly lower seems to indicate that it had not
been learned especially well.
(i)
Pu ,u (t )
u Pu ,u (t )
d Pu ,d (t ) .
(ii)
Pu ,u (t )
d ) Pu ,u (t ) ,
implying that
d (
e
dt
d )t
Pu ,u (t )
de
d )t
Together with the boundary condition Pu,u(0) = 1, this gives the required
solution.
(iii)
E U t | Y0
yu
E I s | Y0
yu ds
P Ys
yu | Y0
yu ds
P ( s ) ds .
0 u ,u
(iv)
t
d
E X t | Y0
d)
1 e
d )t
yu = yd t ( yu
yd ) E U t | Y0
yd
( yu
yd )
d
t
u
u ( yu
yu
yd )
d)
(1 e
d )t
).
Page 5
September 2003
Examiners Report
In general candidates were able to score well on the first two parts, although a common mistake here
was to have the exponential parameters d and u transposed in the Kolmogorov Forward Equations.
In such cases appropriate credit was given for valid attempts at part (ii).
Sn cn
(i)
Mn = e
will be a martingale if E (e
(ii)
Xn
= pe
Sn
c ( n 1)
Fn ) = e
qe , i.e. if pe2
Sn cn
+c
+ q = 0.
Therefore
ec
= ln
(iii)
e 2c 4 pq
.
2p
T1
is bounded.
In this instance, if c 0 and
0 then Mn < e for all n T1. But if c < 0 or
0 then there is no such upper bound and it is not safe to assume that the
OST can be applied.
(iv)
When c > 0, one root for is positive, the other negative, since
pe2 e +c + q < 0 when = 0. We need the positive root.
Applying the OST, E(MT) = M0 = 1 as long as c
that
1 = E (e
ST1 cT1
) = e E (e
cT1
0 and
0. This implies
).
Thus
E (e
cT1
) =e
2p
ec
e 2c 4 pq
ec
e 2c 4 pq
.
2q
In a number of cases, candidates covered some of part (ii) under part (i)
credit was given in these
cases. In general candidates were able to score well on the bookwork required for part (iii) although
candidates were less successful in tackling the final part.
Page 6
(i)
September 2003
Examiners Report
We have
= Cov(Xt, Xt k) =
1
(m 1) 2
(m 1)
Cov(et r , et
k r
k r ).
r 0r 0
0
m k 1
( m 1)2
et
r 0
et r ,
r 0
Cov
2
2
e
= 0.
0,1, 2,..., m.
(ii)
m k 1
m 1
k 1, 2,..., m
For the process to be invertible, we require that the roots of the characteristic
equation should be greater than 1 in absolute value.
We can rewrite the MA model with the aid of the backward shift operator B as
follows:
Xt
1
(1 + B + B2) et.
3
i 3 .
Page 7
September 2003
Examiners Report
(i)
The original data are clearly subject to seasonal variation, and the size of the
seasonal fluctuations is increasing in line with the value of the underlying
quantity. This suggests that the seasonal variation is multiplicative rather than
additive, in which case taking the logarithm is the sensible thing to do. In
addition to this, a look at the plot of yt against time confirms that the variation
is much more regular.
(ii)
(iii)
(iv)
(a)
Estimate the trend by linear regression and remove it, then, for each
month, calculate the sample mean value for that particular month over
all five years. From every detrended observation subtract off the
appropriate seasonal mean to obtain seasonally adjusted data.
(b)
Remove the linear trend by differencing the data once, then remove the
seasonal variation by seasonal differencing. In other words,
zt = (1 B12 )(1 B ) yt .
(a)
The fact that the sample ACF is not near 1 for small lags is the most
obvious pointer to the stationarity of the adjusted data set.
(b)
The clue here is the highest lag for which the ACF or PACF is
significantly different from 0. Looking at the sample ACF we might
suggest that a MA(3) might fit, as the sample ACF is roughly zero for
k > 3. Similarly, a look at the sample PACF seems to indicate an
AR(3). But it might well be possible to find an ARMA(1,1) which
would fit adequately. In other words, d = 0 and either p = 0, q = 3 or
p = 3, q = 0 or p = 1, q = 1.
Page 8
(i)
September 2003
Examiners Report
Transition graph:
to the left.)
1
P=
(ii)
(a)
0
0
(b)
The equations P =
0(1
)+
0 +
1 +
2 +
3 +
0
0
read
1(1
)
)
)
)
)
2(1
3(1
4(1
5(1
4 +
=
=
=
=
=
=
0
1
2
3
4
5
)=
=
1
2(1
0(1
(1
0:
))
)=
2
0
1
j
In general
(c)
Find
0.
by normalisation:
Page 9
September 2003
Examiners Report
6
n
j 0
1=
1
0
1
(iii)
5
j 0
0.5
P( ) > 0, where
5
j 0
j Pj , where
Pj
5
j 0
Pj
1
1
C (1
), where
Candidates showed a good understanding of Markov chains here, with many candidates achieving a
high score. For the final part of the question, a large number of candidates only gave a cursory
explanation and were unable to score the full marks.
(i)
F (t ) = 1 exp
t
65
(a bx)dx = 1 exp
Rearranging,
b 2
t at
2
b 2
65 65a log(1 F (t )) = 0,
2
F (u ) =
Page 10
September 2003
Examiners Report
Since the simulated variable must be positive, the positive root is required.
The method, then, is to generate a pseudo-uniform random variable U in the
range [0,1] and to set
T=
(ii)
(a)
exp
(a bx)dx
65
(iii)
Many candidates correctly identified that the inverse transformation method was required, although
in a surprisingly high proportion of cases marks were lost because of errors in the algebra /
integration. The later parts of this question, dealing with the comparison of two methods of
generating discrete random variables, were in general less well done.
10
(i)
St dt
St dBt .
dSt
(ii)
1
2
St dt
S0 exp( t
St dBt .
We use the It formula (we must have the form where F is a function of t as
well as x):
dF t , X t = Ft t , X t
Let Yt = e t ( X t
c)
1
2
Fx t , X t
dt
Fx t , X t dX t
Page 11
dYt = d e t ( X t
c)
e t[Xt
c]
September 2003
e t[ Xt
Examiners Report
e t dBt
c] dt
= e t dBt
t
e s dBs
Hence Y t = x0 c
s 0
and so X t = c e
( x0 c)
e s dBs .
s 0
(iii)
The required condition for the stationary density of the diffusion Y solving
dYt
(Yt )dt
(Yt )dBt , from the Core Reading, is
d
d2
[ (y) (y)] = 2 [ 2(y) (y)]
dy
dy
(iv)
X t ~ N (c e
( x0 c),
t
0
2 (t s )
ds ) = N c e
, is N(c,
( x c) ( x)
1
2
( x0 c),
1 e
2 t
( x) .
( x) const.exp
( x c)2
2
Page 12
2/(2
)).
A function of the form Axb for all x > 0 cannot integrate to 1, no matter what
the values of A and b. This means that there is no stationary density function
for the geometric Brownian motion.
September 2003
Examiners Report
11
(i)
Model fitting: this occurs after the family of model has been decided and
concerns the estimation of the values of parameters. The set of parameters to
be estimated is determined by the choice of model family.
Model verification: once the model has been fitted we need to check that the
fitted process resembles what has been observed. Generally we produce
simulations of the process, using the estimated parameter values, and compare
them with the observations.
(ii)
The parameters are the rate of leaving state i, i, for each i, and also the jumpchain transition probabilities, rij for j i, where rij is the conditional
probability that the next transition takes the chain to state j given that it is now
in state i. Alternatively, one may regard the parameters as being ij, where ii
=
i and, for j i, ij = i rij.
Assumptions of the Markov model are that the duration of holding time in
state i has exponential distribution with parameter determined only by i and is
independent of anything that happened before the current arrival in state i, and
that the destination of the next jump after leaving state i is independent of the
holding time in state i and of anything that happened before the chain arrived
in state i.
(iii)
1
i
10 per hour,
1
40
1
30
1
6
per minute, or
hour.
r12
3
8
, r13
5
, r21
8
1
, r23
4
3
4
, r31
7
8
and r32
1
.
8
Page 13
10
3.75
September 2003
Examiners Report
6.25
(iv)
One test should test whether the holding times in each state are exponentially
distributed. If Ti,k denotes the kth holding time in state i, then the hypothesis is
that Ti,1, Ti,2, , Ti,ni is a sample from an exponential distribution with
parameter
i:
in each category and hence find the X2 statistic by summing (O E)2/E. This
should be compared with the critical value of the 2 distribution with m 2
d.f., where m is the number of categories.
(v)
Attempts to fit the model to the observed data were generally sensible and encouraging,
although in a minority of cases the calculation of the parameter estimates betrayed evidence
of some confusion. There was a tendency to be less successful as the question continued,
with the result that attempts at the final part were of a noticeably lower standard.
Page 14
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
20 April 2004 (pm)
Subject 103
Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 10 questions, beginning your answer to each question on a separate sheet.
103
A2004
Faculty of Actuaries
Institute of Actuaries
Xt dt +
Xt dBt
where Bt is a standard Brownian motion. Show that the solution to the differential
equation which also satisfies X t0 x is
Xt
for t
x exp
Bt
1
2
Bt0
t t0
t 0.
[4]
A Box-Jenkins model-fitting procedure suggests that the best fitting model for a set of
normalised share price data x1,
, xn is ARMA(1,2), with equation
Xt
0.63 X t
et
0.45et
0.34et
2,
(i)
(ii)
103 A2004
[2]
The number, N(t), of members of a pension scheme who are receiving benefits at time
t, is subject to change of two kinds:
it increases by 1 when an active member reaches retirement age
it decreases by 1 when a retired member dies
Assume that retirements occur according to a Poisson process with rate and that
each retired member, independently, has a probability dt of dying within the time
interval (t, t + dt).
(i)
[1]
(ii)
[1]
(iii)
Using the notation pn(t) = P(N(t) = n), obtain a differential equation satisfied
by pn(t).
[2]
(iv)
1
pn (t ) = e
n!
(v)
n = 0,1,...
[2]
[1]
[Total 7]
The value, St, of a stock exchange index is observed at hourly intervals over the
course of a week, generating observations s1, s2, , sn.
Three different models for St are being considered:
(i)
(a)
St = S 0
(b)
St = S 0 e
(c)
St
( St 1 ) et , where {et: t = 1, 2,
uncorrelated, zero-mean random variables.
, where Bt is as in (a).
} is a sequence of
[3]
(ii)
For EACH of the three models above, outline the steps required during the
process of fitting the model.
[5]
(iii)
Choose ONE of the above models and describe TWO tests you would apply as
part of the model validation process.
[2]
[Total 10]
103 A2004
(i)
(a)
Write down the joint density function of B() and B(1), where
{B(t): t 0} is a standard Brownian motion.
(b)
(ii)
James runs around a running track at the same time as an electric hare which
is programmed to go around in exactly one minute. Let Y(t) denote the
distance (in metres) by which James is ahead of the hare t minutes after the
start and suppose that Y(t) can be modelled as Y(t) = 5 B(t), where B(t) is as
in (i).
(a)
(b)
If James finishes the run 5 metres ahead of the hare, determine the
probability that he was ahead of the hare at time t = 0.5.
[5]
[Total 10]
(i)
(ii)
(iii)
(b)
a
(1 x)a
103 A2004
a 1x 0
P( X = i) =
(iv)
1
n 2
for i 1 2
P( X = 0) =
2
n 2
[4]
(i)
Prove that
d
dt
(b)
Explain why
P(t ) = 0T .
is known as the stationary distribution for X.
[4]
(ii)
A telephone call centre receives calls from customers at an average rate of 0.5
per minute. Each call has a random duration which is exponentially
distributed with mean 3 minutes, independently of the number or duration of
any other calls. Two operators are assigned to handle calls. If a call arrives
when both operators are busy, the call is put on hold unless there are already
two calls on hold, in which case the new call is lost. When a call ends, one of
the calls on hold is immediately put through to the newly free operator.
(a)
(b)
(c)
(d)
103 A2004
A restorer of historic sites travels between Bath, Warwick, Stratford and Caernarvon.
Having arrived at a site, the restorer stays there for a random number of days, then
moves on to one of the others. The restorer s diary for the last two months shows the
following time spent in each place:
Bath (5 days), Warwick (3 days), Caernarvon (7 days), Bath (3 days),
Stratford (7 days), Warwick (5 days), Bath (3 days), Stratford (3 days)
Caernarvon (8 days), Bath (2 days)
A researcher suggests that the path taken by the restorer forms a Markov chain with
state space {Bath, Caernarvon, Stratford, Warwick}.
(i)
(ii)
Discuss, in the light of the data, whether it is likely that this suggestion is
satisfied.
[2]
(iii)
(iv)
State, giving reasons for your answers, whether the Markov chain model is
(a) irreducible, and (b) aperiodic.
[2]
(v)
The restorer arrives in Warwick on day t0. Use the estimated transition matrix
to calculate the probability that he is in Warwick on day t0 + 3.
[3]
[Total 12]
103 A2004
A water company is developing a time series model to model the supply of water, Xt,
in its reservoirs at the end of month t. The model takes the form
Xt = Xt
Rt
Dt ,
( Rt
t 1)
et
Rt
(a)
(ii)
(iii)
(a)
(b)
Calculate a value of
2
R
[1]
2
R
(iv)
(v)
Assuming that the values of the parameters are known exactly, and that R120,
D120 and X120 are known, derive an estimate x120 (1) for the supply of water at
the end of month 121 and give an expression for Var( X121 x120 (1)) .
[3]
[Total 14]
103 A2004
10
(ii)
(iii)
Define Yt = e
(iv)
St
Nt given Nt.
[1]
(a)
(b)
(c)
Let T = inf{t
0 : St
0 or St
if Yt is to be a
is likely to be satisfied in
[6]
that c > .
(a)
(b)
Verify that the conditions of the optional stopping theorem apply to the
stopped martingale Ymin(t ,T ) .
(c)
(d)
(1
)e
ST < 0.
Derive a lower bound for using the result in (iv)(c) and state the
limit of this lower bound as K
.
[6]
[Total 15]
END OF PAPER
103 A2004
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
April 2004
Subject 103
Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
April 2004
Examiners Report
X t dt
1
Xt
Xt
1
2
1
2
X t dBt
1.
2
X t2
dt
f (
X t2 dt
X t2 )dt
1
X t dBt
Xt
dBt
1
2
ln X t0
t t0
Bt
Bt0
Xt
x exp
Bt
1
2
Bt0
t t0
as required.
df t
1
2
ft dt
x exp
1
2
f t dBt
Bt
2
Bt0
1
2
t t0
. Then
2
f
f
2
f,
f,
f , so that
2
B
B
1 2
f t dt
f t dt
ft dBt
2
(i)
For invertibility, we should check that the roots of 1 0.45 z 0.34 z 2 0 are
outside the unit circle. They are ( 0.45 1.25)/( 2*0.34) = 2.5 or 1.18, both
OK.
(ii)
Let
= Cov(Xt, et),
April 2004
= Cov(Xt, et 1),
Examiners Report
Var(0.63 X t
0.632
et
0.45et
(1 0.45 2
0.34 2 )
2 0.63[0.45
0.34
2.
= 0.3969
+ 1.422 2,
implying that
0
= 2.358 2,
= 1.5684 2,
= 0.6481 2.
Candidates were often unsure of the procedure required to derive the equations for the k but
did rather better at solving them. In particular, many candidates did not take correct
account of the relationship between Xt and past values of et. Marks were awarded for correct
methodology when deriving the solutions, even if the equations being solved were not the
right ones.
(i)
(ii)
It is a jump process because it remains in one state for a period of time and
then jumps to another state, or alternatively because it is a continuous-time
process with a discrete state space.
Given the entire past history of the process, the probability of a member
retiring and beginning to receive benefits in the next dt interval is dt, i.e.
independent of the past. The same applies to the probability of death between
times t and t + dt: it is dependent only on the state (the number of retired
members) at time t, and not on anything which happened before that. Thus the
Markov property holds.
n,n 1
n,n 1
Page 3
April 2004
Examiners Report
(iii)
(iv)
The suggested form of pn does not depend on t, so its derivative is zero. The
RHS is
n
(
where
(v)
n )e
n!
n 1
(n 1) e
(n 1)!
n 1
(n 1)!
0,
= / .
Very few candidates suggested that the rate at which deaths take place should be
proportional to the number of retired scheme members.
In (iv) examiners awarded marks for correct attempts to carry out the verification procedure
even when the differential equation in (iii) was wrong.
In (v), terms such as limiting distribution or equilibrium distribution were given full
credit.
(i)
(ii)
(a)
St form a
The first thing to do is to take the log of the observations, obtaining x1,
, xn say. Then apply the same technique as in (a).
(c)
April 2004
Examiners Report
This is a time series model, so a time series technique (such as BoxJenkins) would be appropriate.
Parameters are estimated by Method of Moments or Maximum
Likelihood, or simply by applying a computer package to do the
estimation for you.
(iii)
(b)
(c)
This question differentiated well between candidates, with some very good answers indicating
that the candidates understood the principles and practice of modelling, and others
highlighting deficiencies of understanding.
Page 5
April 2004
Examiners Report
(i)
(a)
If X = B() and Y = B(1), then the marginal distribution of X is N(0,0.5)
and the conditional distribution of Y given X = x is N(x, 0.5).
This means that f X ,Y ( x, y ) is given by
x2
1
.
exp
2(0.5)
2 (0.5)
1
exp
2 (0.5)
(b)
( y x)2
2(0.5)
exp( ( y 2 2 yx 2 x 2 ))
exp
f X ,Y ( x, b)
fY (b)
exp( (b 2 2bx 2 x 2 ))
1
exp b 2
2
2( x b) 2
(a)
P B( 12 )
= 1
(b)
2 B( 12 ) 0
2 = 0.9213.
(1) 0.8413.
This question was designed in such a way that candidates could tackle part (ii) even if part (i)
had not worked out right, but many allowed themselves to become discouraged by difficulties
in the early part of the question and gave up.
(i)
xn in the range {0 1 2
xn
Then un
(axn
April 2004
c) (mod m)
n 12
Examiners Report
(iii)
(a)
x
0
(1 x)
a 1
1
(1 x) a
so the inverse is
F 1 ( y ) (1 y )
1a
1a
1 ) as an
(iv)
i (n 2) , then set X
Page 7
April 2004
Examiners Report
In general, the Pareto offers a suitable choice for portfolios where there is a
non-negligible chance of very large claims, which is reasonable in various
forms of general insurance, in particular insurance that deals with natural
catastrophes (floods, earthquakes, hurricanes etc).
This question was generally well answered and caused few difficulties.
(i)
(a)
We will use the matrix form of the Kolmogorov DE, which states that
P '(t ) AP (t ) .
d T
T dP
T
It follows that
P(t )
AP(t ) 0T P(t ) 0T .
dt
dt
[The other Kolmogorov DE, P '(t ) P(t ) A , cannot be used to complete the proof]
(b)
(ii)
(a)
The states can be labelled as 0, 1, 2:0, 2:1, 2:2, where 0 and 1 represent
the number of operators occupied and 2:j means that both operators are
occupied and j calls are on hold.
Candidates with a different collection of states can earn 0.5 marks, as
long as their states are states. For example, Call arrives is not a
state, but an event triggering a transition from one state to another.
(b)
1/2
0
1/2
1
1/3
1/2
2:0
2/3
1/2
2:1
2/3
2:2
2/3
1/ 2
A
(d)
April 2004
1/ 2
Examiners Report
0
0
1/ 3
5/6
1/ 2
2/3
7/6
1/ 2
2/3
7/6
2/3
1/ 2
2/3
We have
1
2
5
6
7
6
7
6
1
3
1
2
2:0
2:1
1
2
1
2
2
3
2:0
2:0
2
3
2:0
2:1
2
3
2:1
2:2
2:2
192
653
144
653
108
653
3
2
9
0
8
27
0
32
81
0
128
i
must sum to 1.
81
653
(i)
Suppose at time t X has just arrived in state i. The probability that X remains
in state i until time t + k and then leaves, giving a duration of k + 1 steps in
state i, is piik (1 pii ) . In other words, P ( Di ,n d ) piid 1 (1 pii ) , which is
the probability function of a geometric random variable.
The fact that Di,n is independent of previous durations follows from the
Markov property: What happens to X after arriving in state i is independent of
anything that happened before that moment.
(ii)
Page 9
April 2004
Examiners Report
An alternative indication that the Markov property is dubious is the fact that
the restorer appears to return to Bath at regular intervals, i.e. regardless of the
time spent in each state, the path taken appears to lack randomness.
(iii)
pij
nij / ni , where nij is the number of transitions from state i to state j and
ni+ is the total number of transitions out of state i. For example, of the 8 days
spent in Warwick, one is followed by a trip to Caernarvon, one by a trip to
Bath and the remaining 6 are followed by another day in Warwick, so that nWC
= 1, nWB = 1 and nWW = 6. We therefore have (using the order B, C, S, W)
(iv)
9
2 1
0
12
12 12
2 13
0 0
15 15
1 8 1
0
10 10 10
1 1
6
0
8 8
8
(v)
1
1
0
6
.1417
.0111
.1550
.5729 = 0.4488.
8
8
8
8
Each part of this question attracted some unexpected answers as well as some good
ones. The answers to part (i) were on the whole disappointing, but the final parts were
rather better answered in general.
(i)
April 2004
Examiners Report
(a)
(b)
(ii)
(iii)
(a)
[ E ( Rt 1 )
t 1] .
Rt
( R0
0)
et
k 0
(b)
(iv)
120
(rt
)(rt
t 1
t 2
)
.
120
(rt
t 1
Page 11
April 2004
Examiners Report
120
(rt
r )(dt
d)
t 1
120
(rt
r)
t 1
X121
X120
D121
Var( Rt ) to suggest
Rt
Dt .
( R120
0)
e121 and
R121 .
Therefore X121
X120
(1
)[
X120
(1
)2
)[
2
( R120
0 )]
( R120
(1
)e121 , which
0 )]
Most candidates made encouraging progress with this question, though part (iv) proved
difficult for most. In part (v), as well, the relationships between the variables were not
always well understood.
10
(i)
(ii)
(iii)
(a)
E[Yt
| Ft ] e
[u c (t s )]
This is equal to Yt if c
(b)
E[e
Nt
| Ft ] e
[u c (t s ) N t ]
s[ e
1]
[1 e ] .
April 2004
Examiners Report
(iv)
(c)
(a)
(b)
bounded above and below, from which we deduce that the optional
stopping theorem applies.
(c)
(d)
E[YT ] e
1 e
1 e
.
< 0 means that e
0, so in the
There was an error in the final part of the question; where the question asked for a lower
bound, the quantity which could be derived from the previous part of the question was in fact
an upper bound. Candidates who reached the last part and were confused by the error were
treated generously.
It appeared that many candidates tried this question when they were short on time. Those
candidates who attempted part (iv) often did quite well on it, even if they had omitted earlier
parts of the question.
Page 13
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
21 September 2004 (pm)
Subject 103
Stochastic Modelling
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
4.
Attempt all 10 questions, beginning your answer to each question on a separate sheet.
103
S2004
Faculty of Actuaries
Institute of Actuaries
[1]
(ii)
[1]
(iii)
Describe the role of simulation in sensitivity analysis in the given context. [3]
[Total 5]
A person who catches a particular virus for the first time immediately falls ill with
Disease A. The illness lasts for a random length of time, whose mean depends on the
age of the person. Having recovered from Disease A, the person will not fall ill with it
again. However, if the person catches the same virus again after the age of 18, the
result will be Disease B, which will affect the person for an average of three months
regardless of age. After suffering from Disease B the person will not catch the virus
again.
It is proposed that a continuous-time Markov model can be used to model the person s
medical history, with states:
0: not currently ill with Disease A or Disease B
1: currently ill with Disease A
2: currently ill with Disease B
(i)
Explain why the proposed state space is inadequate and suggest an enlarged
state space which can support a Markov model.
[2]
(ii)
(iii)
(iv)
103 S2004
[2]
You are given a stream of standard identically and independently distributed uniform
[0,1] random variables U1, U2, U3, ..
Describe how to use this random variable stream to generate random variates with the
following distributions:
(i)
(ii)
[2]
(iii)
x 10
[3]
otherwise
2
f ( x) =
sin 2 x for 0
0
[3]
otherwise
(i)
(ii)
St dBt , t
0} .
0.
[3]
For the values = 20% and = 15% on an annual basis, calculate the
probability that the price of the share will exceed 120 in three months time if
the current price of the share is 96.
[4]
[Total 9]
(iii)
103 S2004
[2]
A bag contains N balls, all green or red. At each stage a ball is taken out of the bag at
random and is replaced by a ball of the other colour. Let Xn denote the number of
green balls in the bag after n stages.
(i)
Explain why Xn, n 0 is a discrete time Markov chain with state space
S = {0, 1, 2, .., N} and with transition probabilities
pi ,i
N i
and pi ,i
N
i
N
[2]
(ii)
(iii)
(iv)
2N
for i = 0, 1, 2,
= ( 0,
1,
., N.
2,
..,
N)
[4]
j.
[1]
[Total 10]
A model frequently used for interest rates is the Cox-Ingersoll-Ross process, which is
an It process Xt satisfying the stochastic differential equation
dX t = (b X t )dt
X t dBt ,
dm1
= (b m1 )
dt
(b)
103 S2004
0.
[3]
Define Yt = X t2 and m2 (t ) = E[ X t2 | X 0 = x] .
(ii)
(a)
(b)
(c)
Assuming that
limt
dm2
dt
0 as t
Var[ X t | X 0 = x] =
b
2
, show that
2
.
[7]
[Total 10]
1( X t 1
2(Xt 2
p ( Xt p
) et
for 0 k
2
1 k 1
2 k 2
p , where
p k p
= Cov( X t X t
1k
k).
[2]
(ii)
(iii)
103 S2004
0 3Xt
et
(a)
(b)
(c)
Assuming that
2.
[7]
[Total 11]
(i)
(ii)
Explain what it means to say that a time series is stationary and state (but do
not prove) a condition needed to ensure that an ARMA(1,1) process can be
stationary.
[2]
(iii)
(iv)
et
0 17et
The most recently observed value in the series is x25 = 14 82 , with estimated
residual e 25
1 98 .
(a)
(b)
(v)
Vehicles in a certain country are required to be assessed every year for roadworthiness. At one vehicle assessment centre, drivers wait for an average of 15
minutes before the road-worthiness assessment of their vehicle commences. The
assessment takes on average 20 minutes to complete. Following the assessment, 80%
of vehicles are passed as road-worthy allowing the driver to drive home. A further
15% of vehicles are categorised as a minor fail ; these vehicles require on average
30 minutes of repair work before the driver is allowed to drive home. The remaining
5% of vehicles are categorised as a significant fail ; these vehicles require on
average three hours of repair work before the driver can go home.
A continuous-time Markov model is to be used to model the operation of the vehicle
assessment centre, with states W (waiting for assessment), A (assessment taking
place), M (minor repair taking place), S (significant repair taking place) and H
(travelling home).
(i)
(ii)
103 S2004
Explain what assumption must be made about the distribution of the time
spent in each state.
[1]
[2]
(a)
(b)
(c)
t / 20
4e
t /15
for t
0, where t is measured in
0.
[7]
(iii)
Let Ti be the expected length of time (in minutes) until the vehicle can be
driven home given that the assessment process is currently in state i.
(a)
(b)
(c)
Calculate TW.
[4]
[Total 14]
10
and
(i)
(ii)
Show that {S (t ) t
(iii)
0} is a continuous-time martingale.
1 as t
[4]
(a)
Prove that P[ S (t ) a]
(b)
(c)
Explain why the fact that E[ S (Ta )] S (0) does not contradict the
optional stopping theorem.
[5]
(iv)
].
(b)
.
[4]
[Total 14]
END OF PAPER
103 S2004
Faculty of Actuaries
Institute of Actuaries
EXAMINATIONS
September 2004
Subject 103
Stochastic Modelling
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
September 2004
Examiners Report
he examiners were pleased to note that the overall quality of answers on this
final sitting of subject 103 was high and that many of the candidates
demonstrated a good knowledge of the principles and practice of stochastic
modelling. As always, credit was awarded for comments which showed that
candidates had an understanding of the topic covered in a question, even if the
calculations gave the wrong answer due to some mathematical error.
Question 7 was particularly well answered, with Questions 2 and 4 not far
behind. Questions 6 and 10 had the lowest proportion of good answers; it is
possible that time pressure played a role in the case of Question 10.
(i)
Let nij denote the number of direct transitions from state i to state j, with ni+
the total number of transitions out of state i. Then pij nij / ni .
(ii)
Model fitting aims to find the best-fitting model in a given class. But it is
conceivable that even the best-fitting model in the class does not fit very well.
Model validation is a set of procedures to test the adequacy of the fit.
(iii)
(i)
(ii)
0
1
Page 2
AB
A
2
September 2004
Examiners Report
(iii)
(iv)
If, in a population taken as a whole, the number of people in each age group is
roughly constant over time, then the age-dependent transition rates of the
individuals who make up the population can be averaged out to give a timehomogeneous model which works perfectly adequately given that national
medical services are generally only concerned with total numbers falling ill.
This question was answered well in general. Where candidates lost marks it
was often due to mis-specifying the additional states in part (i). Splitting state
A into Has recovered from Disease A and is aged below 18 and Has
recovered from Disease A and is aged 18 or more is reasonable when
modelling an entire population, but does not lead to a time-homogeneous
Markov model when applied to a single individual, since one s 18th birthday
does not occur at a random time. However, answers along these lines with
good explanations were given full marks.
(i)
Set Xi as follows:
A if 0 U i
Xi
(ii)
1/ 5
B if 1/ 5 U i 9 / 20
C if 9 / 20 U i
x 10
4
18
t dt
10 x
36
for 4
x 10 .
10 6 1 U i
10 6 U i
Page 3
September 2004
sup 2sin 2 x
sup f ( x) / g ( x)
0 x
Examiners Report
2.
0 x
If U2 < sin2 V1 let X1 = V1; otherwise reject this value and select a new pair
U1, U2. Repeat for other Xi
Answers to parts (i) and (ii) were generally good. For part (iii) many
candidates only described the general theory without specifying g(x) or
calculating the constant C.
(i)
d (log St )
1
dSt
St
1 1
(dSt ) 2
2
2 St
2
dt
dBt
dt
log St
log S0
or, finally,
St
(iii)
Page 4
We have
S0 e
2
2
Bt
Bt
September 2004
Examiners Report
P St
x S0
Bt
P Bt
2
1
log
1
x
log
y
2
2
x
y
x
y
log
96
02
0 15 and t
0 25 years
The calculations in parts (ii) and (iii) were well done. The definition in part
(i) caused some problems: it is necessary to mention the stationary,
independent increments property; then either of the two remaining properties
(continuous sample paths, normally distributed increments) implies the other.
(i)
The Markov property is clear: the chain jumps either up or down by 1, with
probabilities depending only on the current state, not the past history.
P( X n
i 1| X n
i.
From any state i it is possible to reach any other state j in just |j i| steps,
either all upwards or all downwards. This means that the chain is irreducible.
Every transition takes the chain from an even state to an odd one or vice versa,
which implies that the period must be an even number.
On the other hand, starting from state 0 it is possible to return to 0 in two
steps. Therefore state 0 has period 2 and, by irreducibility, all states have
period 2.
(iii)
To find the stationary distribution we can use the relationship suggested by the
Detailed Balance Equations:
i
N i
N
i 1
for i = 0, 1, 2,
N
i 1
., N
1.
N i
i 1
for i = 0, 1, 2,
., N
Page 5
September 2004
Examiners Report
N
1
N 1
2
N 2
3
N ( N 1)
(2)(1)
N ( N 1)( N 2)
(3)(2)(1)
and in general
N ( N 1)( N 2)
i (i 1)(i 2)
( N i 1)
(2)(1)
N!
( N i )! i !
N
i
Alternatively, write down the transition matrix P and use the equation
T
to obtain
1
N
2
N
N 1
N
To find
3
N
0,
i.e.
N ( N 1)
2
N!
1 ( N i )! i !
(iv)
2N
P=
N ( N 1)( N 2)
3!
+
N
i 0
for i = 0, 1, 2,
N!
i!
, etc.
..+
= ( 0,
2N
1,
2,
= 1
1
2N
..,
N)
is given by
., N
Page 6
(i)
Examiners Report
dm1 d
1
Ex X t
Ex [dX t ]
Ex [b X t ]
(b m1 ) , where Ex
dt
dt
dt
denotes conditional expectation given X0 = x. This derivation uses the
fact that the increments of Brownian motion have expectation equal to
zero.
(a)
d
[e t m1 (t )]
be t , implying that
dt
m1 (t ) e t [ x b(e t 1)] b ( x b)e
(b)
(ii)
September 2004
dYt
(a)
(dX t ) 2
2 X t dX t
[2 b
2 X t [ (b X t )dt
X t dBt ]
X t dt
] X t dt 2 X t2 dt 2 X t3/ 2 dBt
d
2
m2 (t ) [2 b
]m1 (t ) 2 m2 (t ). Again we have used the fact
dt
that Brownian increments have mean zero.
(b)
(c)
We do not need to solve the equation, but just to note that since dm2/dt
tends to 0, this implies that 2 limt
m2(t) = [2 b + 2] limt
m1(t)
= 2 b2 + b 2. Therefore
b 2
limt
E[ X t2 | X 0 x] b 2
, from which we deduce that
2
b 2
.
limt
Var[ X t | X 0 x]
2
(i)
Cov( X t X t
k)
1Cov( X t 1
Xt
k)
Xt
k)
p Cov ( X t p
Xt
k)
A diagnostic test is based on the partial ACF and uses the fact that, for an
AR(2) process, the partial autocorrelations, k , are zero for k 2 .
Page 7
The values of
September 2004
asymptotic variance of
(a)
, and for k
2 the
Examiners Report
06
(0 6) 2 1 2
i.e. the roots are 1
06
156 6 .
Since both roots lie outside the unit circle, the process can be
stationary.
(b)
(c)
06
03
(3)
06
03
(4)
06
03
(5)
07
06
6 0
7
(6)
36
70
3
10
57
70
(7)
36
70
171
700
which gives
Page 8
36
70
171
700
700
169
given the
September 2004
Examiners Report
6 0
7
600
169
570
169
The examiners were pleased to note the high quality of answers to this
question. It appears that the theoretical principles of Time Series analysis are
well understood.
(i)
The equation is
Xt
( Xt
) et
et
1 is needed.
in terms
by equating
with r1 and
with r2 .
The value of 2 is estimated using the calculated value of
variance, whereas an estimate for is the sample mean x .
(iv)
(a)
22 827
x 24(1)
x25
x 24(1)
Page 9
(v)
September 2004
Examiners Report
Exponential smoothing is simple to apply and does not suffer from problems
of over-fitting. If the data appear fairly stationary but are not especially well
fitted by any of the Box-Jenkins methods, exponential smoothing is likely to
produce more reliable results. More advanced versions of exponential
smoothing can cope with varying trends and multiplicative variation.
Many candidates omitted to mention as a parameter in part (i). Marks for
this question were not quite as good as for Q7, indicating that the practical
aspects of Time Series analysis are less well understood than the theoretical
ones.
(i)
The Markov model implies that holding times are exponentially distributed.
(ii)
1
400
1
25
1
30
1
180
3
400
1
30
1
180
W
A
M
S
H
(a)
1
15
1
20
1
15
4
0
0
0
4
0
0
0
3 0.45 0.15 2.4
0
2
0
2
1
1
0
0
3
3
d
pWM (t )
dt
d
pWA (t )
dt
d
pWM (t )
dt
d
pWA (t )
dt
Page 10
1
3
pWM (t )
pWA (t )
30
400
1
1
pWA (t )
pWW (t )
20
15
2 pWM (t ) 0.45 pWA (t )
3 pWA (t ) 4 pWW (t )
(b)
September 2004
Examiners Report
First note that pWW(t) = e t/15. Then try inserting the given formula in
the second equation above:
LHS
d
pWA (t )
dt
1
e
5
t / 20
4
e
15
t /15
and
RHS
1
1
pWA (t )
pWW (t )
20
15
1
e
5
1
e
5
t / 20
t /15
1
e
15
t /15
d t / 30
3 t / 30
e
pWM (t )
e .4 e t / 20 e t /15 with pWM(0) = 0
dt
400
t / 30
implies that e
pWM (t ) 0.9 1.8e t / 60 0.9e t / 30 , which simplifies
to pWM (t ) 0.9e
(iii)
t / 30
1.8e
t / 20
0.9e
t /15
(a)
(b)
(c)
TA
= 20 + 0.15 TM + 0.05 TS
TM
= 30
TS
= 180
10
(i)
(ii)
Bt . In this case
1.
Page 11
E St S s
Ss
September 2004
s t
Examiners Report
N ( t t ) , so that M t ( x) e
x tx 2 2
We have
E St S s
E e
e
E e
2 W (t )
Ss
2 W (t ) W ( s ) W ( s )
2 W (s)
E e
Ss
2 (W (t s ))
(1)
W (t s )
N ( (t s ) (t s ))
(2)
so
E e
where M t
2 (W (t s ))
Mt s ( 2 )
(t s ) x (t s ) x 2 2
Therefore
Mt s ( 2 ) e
(t s ) (t s )(2 )2 2
S s as required.
(iii)
Page 12
(a)
E[ St ] E[e
2 W (t )
0 , so
] Mt ( 2 ) e
t ( 2 ) t ( 2 )2 2
September 2004
b
2
P B(t )
0 we have
P B (t )
Examiners Report
b
2
P[Ta
t ] P[ S (t )
a]
By definition, S (Ta )
(iv)
0 as t
a . Therefore E[ S (Ta )] a .
(c)
(a)
a
0
if Ta
if Ta
].
1
a
In part (ii) a large number of candidates did not even attempt to prove that
E (| St |)
: this condition is a requirement for S to be a martingale and
should not be omitted. However, most candidates had a good idea of how to
prove that S satisfied the conditional expectation condition.
Parts (iii) and (iv) attracted at best sketchy answers. The examiners were
unsure whether this was due to pressure of time or to lack of familiarity with
applications of the optional stopping theorem.
1 S (0)
aP[Ta
i e that P[Ta
Page 13