On Complex Economic Scenario Generators: Is Less More?

Abstract

This article proposes a complex economic scenario generator that nests versions of well-known actuarial frameworks. The generator estimation relies on the Bayesian paradigm and accounts for both model and parameter uncertainty via Markov chain Monte Carlo methods. So, to the question is less more?, we answer maybe, but it depends on your criteria. From an in-sample fit perspective, on the one hand, a complex economic scenario generator seems better. From the conservatism, forecasting and coverage perspectives, on the other hand, the situation is less clear: having more complex models for the short rate, term structure and stock index returns is clearly beneficial. However, that is not the case for inflation and the dividend yield.

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“…Specifically, in 2005, Ahlgrim, D'Arcy, and Gorvett proposed a model similar to Wilkie's but allowed for regime-switching dynamics for stock index returns to capture bull and bear markets. More recently, Bégin (2021) introduced a new cascade-type ESG based on the monetary policy, which is modeled via observable regime-switching dynamics. The model also considers the changing nature of the variance via generalized autoregressive conditional heteroskedasticity (GARCH) models.…”

“…The model also considers the changing nature of the variance via generalized autoregressive conditional heteroskedasticity (GARCH) models. In the present article, we rely on a modified version of Bégin's (2021) model. Specifically:…”

“…-We use a homoskedastic autoregressive model for price inflation, wage inflation, and the dividend yield with (monetary) regime-dependent long-run levels, as supported by the conclusions of Bégin (2021Bégin ( , 2023. -We rely on sophisticated models for the short rate, the stock index and alternative asset returns, as well as the investment grade corporate bond yields.…”

“…Our sample period extends from 1998 to 2020. The parameters are obtained by Markov chain Monte Carlo methods similar to those used in Bégin (2021). Section SM.A of the Supplementary Material gives additional details about the ESG, the data used, and some of the estimation results.…”