A Stochastic Investment Model for Asset and Liability Management

This paper describes a stochastic investment model, designed for use as a tool in the asset and liability management of UK pension finds. A full description of the model is given, including the equations and parameters. Rates of return are not modelled directly, but are transformed into forces of return. Modelling forces makes the relationships between the variables additive rather than multiplicative. This is the first fully published model to use earnings rather than dividends to generate price returns. Another feature of the model is that the equity return is divided into three components - dividend yield, earnings growth, and change in market rating. By modelling these components separately the model is able to capture one of the key features of the equity market, namely the high short term volatility (which derives from market sentiment) and the much lower long term volatility (which arises from economic fluctuations). The technique of decomposing the return should be applicable to other equity markets around the world.

Keywords: Stochastic Investment Modelling, Asset/Liability Modelling, Price Earnings Ratio, UK Equity, Pension Fund and Insurance Companies.