Special Issue “Machine Learning in Insurance”

Learning in Insurance”, which represents a compilation of ten high-quality articles discussing avant-garde developments or introducing new theoretical or practical advances in this field

Efficient valuation of exotic derivatives with path-dependence and early exercise features

The main objective of this thesis is to provide effective means for the valuation of popular financial derivative contracts with path-dependence and/or early-exercisable provisions. Starting from the risk-neutral valuation formula, the approach we propose is to sequentially compute convolutions of the value function of the contract at a monitoring date with the transition density between two dates, to provide the value function at the previous monitoring date, until the present date. A rigorous computational algorithm for the convolutions is then developed based on transformations to the Fourier domain. In the first part of the thesis, we deal with arithmetic Asian options, which, due to the growing popularity they enjoy in the financial marketplace, have been researched signicantly over the last two decades. Although few remarkable approaches have been proposed so far, these are restricted to the market assumptions imposed by the standard Black-Scholes-Merton paradigm. Others, although in theory applicable to Lévy models, are shown to suffer a non-monotone convergence when implemented numerically. To solve the Asian option pricing problem, we initially propose a flexible framework for independently distributed log-returns on the underlying asset. This allows us to generalize firstly in calculating the price sensitivities. Secondly, we consider an extension to non-Lévy stochastic volatility models. We highlight the benefits of the new scheme and, where relevant, benchmark its performance against an analytical approximation, control variate Monte Carlo strategies and existing forward convolution algorithms for the recovery of the density of the underlying average price. In the second part of the thesis, we carry out an analysis on the rapidly growing market of convertible bonds (CBs). Despite the vast amount of research which has been undertaken yet. This is due to the need for proper modelling of the CBs composite payout structure and the multi factor modelling arising in the CB valuation. Given the dimensional capacity of the convolution algorithm, we are now able to introduce a new jump diffusion structural approach in the CB literature, towards more realistic modelling of the default risk, and further include correlated stochastic interest rates. This aims at fixing dimensionality and convergence limitations which previously have been restricting the range of applicability of popular grid- based, lattice and Monte Carlo methods. The convolution scheme further permits flexible handling of real-world CB specications; this allows us to properly model the call policy and investigate its impact on the computed CB prices. We illustrate the performance of the numerical scheme and highlight the effects originated by the inclusion of jumps

Self-selection and risk sharing in a modern world of lifelong annuities - Abstract of the London Discussion

This abstract relates to the following paper: Gerrard, R., Hiabu, M., Kyriakou, I. and Nielsen, J. P. (2018) Self-selection and risk sharing in a modern world of lifelong annuities ‐ Abstract of the London Discussion. British Actuarial Journal. Cambridge University Press, 23. doi: 10.1017/S135732171800020X

Self-selection and risk sharing in a modern world of life-long annuities

Communicating a pension product well is as important as optimising the financial value. In a recent study, we showed that up to 80% of the value of a pension lump sum could be lost if customer communication failed. In this paper, we extend the simple customer interaction of the earlier contribution to the more challenging lifetime annuity case. Using a simple mobile phone device, the pension customer can select the life-long optimal investment strategy within minutes. The financial risk trade-off is presented as a trade-off between the pension paid and the number of years the life-long annuity is guaranteed. The pension payment decreases when investment security increases. The necessary underlying mathematical financial hedging theory is included in the stud

Hedging of Asian options under exponential Lévy models: computation and performance

In this paper we consider the problem of hedging an arithmetic Asian option with discrete monitoring in an exponential Lévy model by deriving backward recursive integrals for the price sensitivities of the option. The procedure is applied to the analysis of the performance of the delta and delta-gamma hedges in an incomplete market; particular attention is paid to the hedging error and the impact of model error on the quality of the chosen hedging strategy. The numerical analysis shows the impact of jump risk on the hedging error of the option position, and the importance of including traded options in the hedging portfolio for the reduction of this risk

Herd behavior in the drybulk market: An empirical analysis of the decision to invest in new and retire existing fleet capacity

We examine whether investors herd in their decision to order or scrap vessels in the drybulk market. We decompose herding into unintentional and intentional, and test for herd behavior under asymmetric effects with respect to freight market states, cycle phases, risk-return and valuation profiles, and ownership of the vessel. We detect unintentional herd behavior during down freight markets and contractions. Furthermore, we find evidence of spill-over unintentional herding effects from the newbuilding to the scrap market. Finally, asymmetric herd effects are evident between traditional and liberal philosophy towards the ownership of the vessel, and during extreme risk-return and valuation periods

A general framework for pricing Asian options under stochastic volatility on parallel architectures

In this paper, we present a transform-based algorithm for pricing discretely monitored arithmetic Asian options with remarkable accuracy in a general stochastic volatility framework, including affine models and time-changed Lévy processes. The accuracy is justified both theoretically and experimentally. In addition, to speed up the valuation process, we employ high-performance computing technologies. More specifically, we develop a parallel option pricing system that can be easily reproduced on parallel computers, also realized as a cluster of personal computers. Numerical results showing the accuracy, speed and efficiency of the procedure are reported in the paper

Forecasting benchmarks of long-term stock returns via machine learning

Recent advances in pension product development seem to favour alternatives to the risk free asset often used in the financial theory as a performance standard for measuring the value generated by an investment or a reference point for determining the value of a financial instrument. To this end, in this paper, we apply the simplest machine learning technique, namely, a fully nonparametric smoother with the covariates and the smoothing parameter chosen by cross-validation to forecast stock returns in excess of different benchmarks, including the short-term interest rate, long-term interest rate, earnings-by-price ratio, and the inflation. We find that, net-of-inflation, the combined earnings-by-price and long-short rate spread form our best-performing two-dimensional set of predictors for future annual stock returns. This is a crucial conclusion for actuarial applications that aim to provide real-income forecasts for pensioners

Forecasting crude oil and refined products volatilities and correlations: New evidence from fractionally integrated multivariate GARCH models

The relationship between the prices of crude oil and its refined products is at the heart of the oil industry. Crude oil and refined products volatilities and correlations have been mod- elled extensively using short-memory multivariate GARCH models. This paper investigates the potential benefits from using fractionally integrated multivariate GARCH models from a fore- casting and a risk management perspective. Several models for the spot returns on three major oil-related markets are compared. In-sample results show significant evidence of long-memory decay and leverage effects in volatilities and of time-varying autocorrelations. The forecasting performance of the models is assessed by means of three approaches: the Superior Predictive Ability test, the Model Confidence Set and the Value-at-Risk. The results indicate that the multivariate models incorporating long-memory outperform the short-memory benchmarks in forecasting the conditional covariance matrix and associated risk magnitudes. The paper makes an innovative contribution to the analysis of the relationship between crude oil and its refined products providing refiners, physical oil traders, non-commercial oil traders and other energy markets agents with significant insights for hedging and risk management operations

Longer-Term Forecasting of Excess Stock Returns—The Five-Year Case

Long-term return expectations or predictions play an important role in planning purposes and guidance of long-term investors. Five-year stock returns are less volatile around their geometric mean than returns of higher frequency, such as one-year returns. One would, therefore, expect models using the latter to better reduce the noise and beat the simple historical mean than models based on the former. However, this paper shows that the general tendency is surprisingly the opposite: long-term forecasts over five years have a similar or even better predictive power when compared to the one-year case. We consider a long list of economic predictors and benchmarks relevant for the long-term investor. Our predictive approach consists of adopting and implementing a fully nonparametric smoother with the covariates and the smoothing parameters chosen by cross-validation. We consistently find that long-term forecasting performs well and recommend drawing more attention to it when designing investment strategies for long-term investors. Furthermore, our preferred predictive model did stand the test of Covid-19 providing a relatively optimistic outlook in March 2020 when uncertainty was all around us with lockdown and facing an unknown new pandemic