ClearHorizon Technical Document

TM

Jongwoo Kim
Contributor: Jorge Mina

This draft: August 28, 2000

Forecasting Methodology for Horizons Beyond Two Years

ClearHorizonTM Technical Document, First Edition (June 2000)
© 2000 The RiskMetrics Group
Copyright © 2000 The RiskMetrics Group, LLC. All Rights Reserved. The RiskMetrics Group hereby grants
you a non-exclusive, limited, revocable license to use the ClearHorizonTM Technical Document provided that
you comply with the following requirements. You must not edit, delete, supplement, alter or modify the
ClearHorizon Technical Document including its text, charts, formulas, graphics, copyright notice, trademark
notice and/or the names and e-mail addresses of the authors. You acknowledge that the formulas that appear
in the ClearHorizon Technical Document are proprietary to RiskMetrics. You may not use, duplicate or
distribute any one or more of the formulas that appear in the ClearHorizon Technical Document for any
purpose other than to evaluate the ClearHorizonTM measurement services, including how the ClearHorizon
methodology works. Any other use, copying and distribution of the ClearHorizon Technical Document is
prohibited. The RiskMetrics Group reserves the right to terminate this limited license on notice to you.
ClearHorizonTM , FortuneManagerTM , PensionMetricsTM , RiskGradeTM , RiskGradesTM , RiskMetrics® , and the
Circle Design Logo are trademarks and service marks owned by or licensed to The RiskMetrics Group, LLC.
Without the express written approval of The RiskMetrics Group, you may not use the trademarks or service
marks for any purpose other than to designate that these marks are owned by or licensed to The RiskMetrics
Group, LLC.
The RiskMetrics Group does not warrant any results obtained from the use of the ClearHorizon method-
ology, RiskGrades measures, data, methodology, documentation or any information derived from the data
(collectively the "Data") and does not guarantee its sequence, timeliness, accuracy, completeness or con-
tinued availability. The Data is calculated on the basis of historical observations and should not be relied
upon to predict future market movements. The Data addresses market risk measurement and should not be
relied upon to measure all of a company’s other risk types, such as credit, operational, business, legal, or
reputational risks. The information contained in this document is believed to be reliable but The RiskMetrics
Group does not guarantee its completeness or accuracy. Opinions and estimates constitute our judgement
and are subject to change without notice. Copyright 2000 The RiskMetrics Group, LLC.
Contents

1 Introduction 1

2 Forecasting Methodology 3
2.1 Two Basic Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 A Hybrid Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3 Forecasting Examples 15
3.1 Estimation of Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.2 Degree of Mean Reversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.3 Additional Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

4 Applications of ClearHorizon 23
4.1 FortuneManagerTM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.2 Pension Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

iii
iv CONTENTS

RiskMetrics
Chapter 1

Introduction

When RiskMetrics® [6] was first released in 1994 to introduce J.P. Morgan’s non-proprietary Value-at-Risk
(VaR) methodology, it was accepted as a revolutionary risk measurement tool for the financial industry.
RiskMetrics was originally invented for investment banks, whose day-to-day trading operations require
frequent and quick adjustments of the banks’ portfolios. The RiskMetrics VaR calculation therefore involved
short horizons, from overnight to three months. Two of the key assumptions made in RiskMetrics are that
the expected return on any asset is zero, and the asset’s volatility beyond a one-day horizon is scaled up from
the RiskMetrics daily volatility according to the square root of time rule. These are innocuous assumptions
in the short-term forecasting context of RiskMetrics.
However, the demand for market risk measurement over long horizons continues to increase. For example,
non-financial corporations are less sensitive to daily market moves and focus on long-term fluctuations
when gauging their performance. Consequently, their budgeting and planning horizons extend to one year
and longer. To provide a dedicated and robust long-term risk measurement framework, we first developed
LongRunTM [4], which focuses on market risk scenarios for time horizons up to two years. LongRun starts
with the basic understanding that the random walk model, which forms the RiskMetrics framework, does
not always provide the best explanation for the dynamics of financial returns over long horizons. LongRun
then provides two basic approaches to long-term forecasting of future asset returns: Forecasts based on
current market prices make intensive use of spot, futures, forwards and options price data as well as basic
derivatives theory, while forecasts based on economic fundamentals rely on historical time series of financial
and economic data and on econometric modeling of time series.
LongRun was launched in the spring of 1999 and created a deep impact on corporate treasuries. It also
stimulated the demand for a third type of market risk methodology, one that can generate forecasts for time
horizons beyond two years. The greatest demand for a longer-term forecasting method comes from the
mutual funds and pension plans industries. Their main source of risk is market price fluctuations, which they
track for at least 30 years. In addition, pension plans and insurance companies have longer-term liabilities in

1
2 CHAPTER 1. INTRODUCTION

the form of annuities or insurance claim payments. LongRun, however, is limited to a two-year forecasting
horizon; for the forecasts based on current market prices, it is difficult to find derivatives prices whose
expiration dates exceed two years, while for the forecasts based on economic fundamentals, it is difficult to
justify how econometric modeling can remain valid beyond a two-year horizon.
In this technical document, we introduce ClearHorizon, which we designed to provide robust forecasts
for generating scenarios to measure market risk beyond periods of two years. In contrast to LongRun,
ClearHorizon is time-series specific, i.e., ClearHorizon uses only those properties that are specific to the time
series of each asset included in the forecast. More precisely, ClearHorizon determines the optimal mixture
of the random walk and mean reversion properties of an asset’s price.
In Chapter 2, we explain the forecasting methodology of ClearHorizon. First, we estimate two extreme time
series models: the random walk and mean reversion. We then determine the weighting factors for each model
in the optimal mixture in order to best calibrate the optimal mixture model to the historical behavior of an
asset’s price. Finally, we calculate the expected returns and volatilities for the pre-specified set of future dates
according to the optimal mixture model. The model’s expected-return forecasts capture the long-term trend
that is specific to a given asset’s price, and its volatility forecasts explicitly incorporate the mean reversion
property of the asset’s price.
Chapter 3 presents 23 examples of asset price forecasting across several instruments: foreign exchange, short
and long-term government bonds, equity indices, and commodities. The degree of mean reversion varies
across asset prices, which the optimal mixture model is able to incorporate in the forecasting.
Chapter 4 presents two applications of ClearHorizon forecasting. One application is FortuneManagerTM ,
which is a simulation-based risk management solution for long-horizon investment. While many individual
investors use RiskGradesTM to manage their money for various investment horizons, FortuneManager provides
more specific risk measurements focusing on long-term investment, such as retirement plans. The other
application is pension risk management in which ClearHorizon is used to assess liability-related risks of
pension funds, as well as their asset-related risks.

RiskMetrics
Chapter 2

Forecasting Methodology

2.1 Two Basic Models

We start our discussion by introducing two basic time series models: the random walk and mean reversion
(see Metcalf and Hassett [5]).
Let Pt denote the asset price for which we will forecast the mean and volatility for a pre-specified set of
future dates. If the asset price follows the Geometric Brownian Motion (GBM) process, it can be described
by the following equation:

dPt = αPt dt + σ Pt dz, (2.1)

where α denotes the trend coefficient, σ is the standard deviation, and z denotes a Wiener process with zero
mean and unit variance.
Let pt denote the logarithm of Pt . To estimate parameters based on the discrete historical data of Pt , we can
express Equation 2.1 as the following discrete version:

1pt = pt − pt−1 = α + σ t , (2.2)

where t denotes a random error term that follows the standard normal distribution, and parameters α and σ
in Equation 2.2 are equivalent to α and σ in Equation 2.1.

3
4 CHAPTER 2. FORECASTING METHODOLOGY

Usually, we refer to 1pt as a random walk process and to pt as a difference stationary series. 1 From this
point, we simply call 1pt a random walk (RW). Including the time parameter t, the mean (µRW,k ) and
2
variance (σRW,k ) of pt+k are calculated as follows:

µ̂RW,k = k α̂ + pt (2.3)

σ̂RW,k
2
= k σ̂RW,1
2
, (2.4)

where α̂ and σ̂RW,1

2
are the parameters that were estimated in Equation 2.2.
Next, if the asset price follows the Geometric Mean Reversion (GMR) process, it can be described by the
following equation:

h i
dPt = ά + γ́ (P0 eάt − Pt ) Pt dt + σ́ Pt dz, (2.5)

where parameter γ́ has a positive value and represents the speed of mean reversion. When the trend coefficient
ά equals zero, Equation 2.5 degenerates to the Geometric Ornstein-Uhlembeck (GOU) process.
The GMR process of Equation 2.5 can be expressed as the following discrete form 2

1pt = pt − pt−1 = ά + γ́ [p0 + ά(t − 1) − pt−1 ] + σ́ t , (2.6)

then,

pt = γ́ (p0 + άt) + (1 − γ́ )(ά + pt−1 ) + σ́ t

= α + βt + γpt−1 + σ t , (2.7)

where parameters α, β, γ , and σ are equivalent to γ́ p0 + (1 − γ́ )ά, γ́ ά, (1 − γ́ ), and σ́ in Equation 2.6,
respectively.
Parameter γ (or γ́ ) has a value between 0 and 1, and represents the speed of mean reversion. If γ equals 1 (or
γ́ equals 0), the process degenerates to the random walk; if γ is significantly less than 1 (or γ́ is significantly
larger than 0), the process shows strong mean reversion properties.
1 For a detailed discussion of stationary and nonstationary time series, see Chapter 15 of Hamilton [3].
2 It does not mean that the continuous form of Equation 2.5 and the discrete form of Equation 2.6 are equivalent.

RiskMetrics
2.1. TWO BASIC MODELS 5

Usually, we refer to pt as a mean reversion process, or a trend stationary series. From this point, we will
simply call it mean reversion (MR). Including the time parameter t, the mean (µMR,k ) and variance (σMR,k
2
)
of pt+k are calculated as follows:

 
α̂(1 − γ̂ k ) β̂ γ̂ (1 − γ̂ k−1 )
µ̂rm,k = + (t + k) − γ̂ k (t + 1) − + γ̂ k pt (2.8)
1 − γ̂ 1 − γ̂ 1 − γ̂

σ̂MR,1
2
(1 − γ̂ 2k )
σ̂MR,k
2
= , (2.9)
1 − γ̂ 2

where α̂, β̂, γ̂ and σ̂MR,1

2
are the parameters that were estimated in Equation 2.7.
As an example, we estimated Equation 2.2 (random walk model) and Equation 2.7 (mean reversion model)
by using the USD month-end prices in the period January 1986 to April 2000. Parameters α, β, and γ were
estimated from the Ordinary Least Squares method (OLS) and σ was estimated from the standard deviation
of residuals. For each model, the estimated results are presented in Table 2.1.

Table 2.1: Parameters Estimated by Random Walk and Mean Reversion

Random Walk Mean Reversion

Asset α σ α β γ σ
USD S&P 500 0.0113 0.0450 0.2524 0.0005 0.9536 0.0444

The estimated mean reversion parameter γ̂ is 0.9567, i.e., less than 1, which is important in determining
whether a series is difference stationary or trend stationary, as discussed in the next section. 3
In this section we demonstrate how the two models generate different forecasts of the S&P 500 in USD.
To determine how quickly variance changes with forecast horizon for each model, we calculate the variance
ratio (VR) for each model from the following equation:

σ̂k2
V Rk = . (2.10)
k σ̂12
3 The unit root test determines whether a time series is difference stationary or trend stationary, based on the estimated γ . If the
estimated γ is significantly far away from unity, the test rejects the null hypothesis of the difference stationary time series (so-called
unit root process). For a detailed discussion of the unit root test, see Hamilton [3], Chapter 15.

ClearHorizonTM Technical Document

6 CHAPTER 2. FORECASTING METHODOLOGY

Figure 2.1 plots the variance ratio of USD S&P 500 forecasts up to ten years. The variance ratio of the random
walk model is always 1 according to Equation 2.4, which means that the volatility or standard deviation of
the random walk increases proportionally to the square root of its forecast horizon (the so-called square root
of time rule). For the mean reversion model, the Variance Ratio starts at 1 and steadily decreases as the
forecast horizon increases. Equation 2.4 confirms that σMR,k
2
is less than kσMR,1
2
as long as γ is less than 1.
The lower chart in Figure 2.1 plots the standard deviations calculated from the two models. The standard
deviation of the random walk is always greater than the standard deviation of the mean reversion model.
Furthermore, it increases continuously while the standard deviation of the mean reversion model remains at
a nearly constant value after a certain number of years within the time horizon. As a result, the gap between
the standard deviations of the two models widens as the forecast horizon increases.
Although the difference between γ and unity can be very small and can seem quantitatively trivial, it is
critical in forecasting the mean and confidence intervals. The reason is that γ determines the choice of model
— a γ equal to unity requires the use of the random walk, while γ less than unity requires use of the mean
reversion model. For a more detailed discussion, see Hamilton [3], Chapter 15.
Figure 2.2 compares the random walk and mean reversion models with respect to their mean and 90%
confidence interval forecasts of the logarithmic value of USD S&P 500 from May 2000. The mean forecasts
of the random walk model increase in parallel to the long-term path, and never die out. This means that any
kind of price movement due to today’s information or shock persists and is continuously accumulated (i.e.,
all shocks are permanent shocks). The future price, then, is nothing more than an accumulation of price
movements across the forecasting horizon. Since information or shock is continuously generated and affects
the price as time goes on, the standard deviation of the price should also increase continuously as time goes
on. In addition, the size of the confidence interval is determined by the standard deviation forecasts, and
therefore the confidence interval also continuously increases.
By contrast, the mean forecasts of the mean reversion model coincide exactly with the long-term path, after
their initial deviations from the long-term path quickly die out. This means that any kind of short-term price
movement that is caused by current information or shock disappears in the long run (the speed of disappearance
is determined by the mean reversion parameter γ ) and is not accumulated (i.e., all shocks are transitory).
The future price is nothing more than the long-term price that is observed when the forecast horizon becomes
sufficiently long to capture price recovery; although new information or shock is continuously generated and
affects the price as time goes on, its effect disappears in the long run, and the price recovers to follow the
long-term path. Therefore, the standard deviation of the price does not increase continuously, which we have
already shown in Figure 2.1.

2.2 A Hybrid Model

One way to generate long-term forecasts of asset price is by selecting either the random walk or the mean
reversion model according to the unit root test, and then applying the selected model to the mean and variance

RiskMetrics
2.2. A HYBRID MODEL 7

Figure 2.1: Volatilities Computed from the Random Walk and Mean Reversion Models

Variance Ratio of USD S&P 500

1.2

1
variance ratio

0.8

0.6

0.4

0.2

0
0 20 40 60 80 100 120

Volatility of USD S&P 500

Random Walk
0.6 Mean Reversion
0.5
volatility

0.4

0.3

0.2

0.1

0
0 20 40 60 80 100 120
time horizon, month

ClearHorizonTM Technical Document

8 CHAPTER 2. FORECASTING METHODOLOGY

Figure 2.2: Forecasts of the Random Walk and Mean Reversion Models

Random Walk Forecasts of USD S&P 500 from May 2000

9.5
mean forecasts
long−term trend
9

8.5
log price

7.5

7
−20 0 20 40 60 80 100 120

Mean Reversion Forecasts of USD S&P 500 from May 2000

9.5

8.5
log price

7.5

7
−20 0 20 40 60 80 100 120
time horizon, month

RiskMetrics
2.2. A HYBRID MODEL 9

forecasts. However, a large number of time series studies have been reported to prove that any unit root test
has very low test power for finite samples. Furthermore, Cochrane [1] explains the low test power of the
unit root test by the fact that any time series with a unit root can be decomposed into a stationary series and
a random walk.
Therefore, we interpret the random walk and mean reversion models in the previous section as the extremes
of a broad spectrum of possible models. At one extreme, we can consider the random walk to be a model that
provides the maximum possible volatility, since it denies the existence of mean reversion properties for any
time series. (However, many time series studies have been reported to confirm the mean reversion property
of asset prices in the long-term, especially interest rates (see Wu and Zhang [7].) At the other extreme, we
can consider mean reversion (specifically the GMR version) as a model that provides the minimum possible
volatility. The small volatility is valid only when the parameters of the mean reversion model are correctly
specified and constant through the forecasting horizon. In other words, today’s information and shock do
not change the long-term trend of the price.
Based on this reasoning, we assume that the true model of an individual asset’s price is a mixture of random
walk and mean reversion models (i.e., while some shocks are permanent, others are transitory). To confirm
this assumption, we need to design a way to determine the optimal weighting factors of the two models. One
practical way is to determine the weighting factor for an individual series as the factor that best calibrates the
degree of mean reversion to the historical data of the same series.
To measure the degree of mean reversion, we generally use the variance ratio. The equation for the variance
ratio for historical data is the same as Equation 2.10, except that the variance of k-period forecasts is calculated
from the following equation (see Glen [2]):

Xn
n
σ̂k2 = (pi − pi−k − k r¯1 )2 , (2.11)
(n − k)(n − k + 1) i=k+1

where n denotes the total number of observations, and r¯1 denotes the one-period historical average return.
It is worth noting that since it is calculated from actual data, the variance ratio for historical data does not
have a geometric shape like the random walk (constant at 1) or the mean reversion (geometrically monotonic
decreasing) models.
Next, we determine the weighting factors ω and (1-ω) for the variance ratios of the random walk and mean
reversion, respectively, such that the variance ratio of the optimal mixture best calibrates to the variance ratio
of the historical samples. To estimate the weighting factor, we use the least squares method and minimize
the following equation with respect to ω:

q
X  2
min V RH S,k − (ωV RRW,k + (1 − ω)V RMR,k ) , (2.12)
k=1

ClearHorizonTM Technical Document

10 CHAPTER 2. FORECASTING METHODOLOGY

where V RH S,k denotes the variance ratio of historical data and q denotes the maximum forecast horizon.
Using historical data as well as the estimated random walk and mean reversion models for USD S&P 500
in the previous section, we estimated the weighting factor for the optimal mixture to be 0.8013. This means
that the degree of mean reversion in the historical data of USD S&P 500 is calibrated by 80% of the random
walk and 20% of the mean reversion model.
The upper chart in Figure 2.3 plots the variance ratios of the optimal mixture, random walk, and mean
reversion models. We can easily check that the variance ratio of the optimal mixture fits the historical data
quite well. In addition, it has a geometrically monotonic decreasing shape as the forecast horizon increases,
which guarantees a smoothly increasing monotonic shape for the confidence interval.
The lower chart in Figure 2.3 shows the standard deviations estimated from the optimal mixture, random
walk, and mean reversion models. In the case of USD S&P 500, the standard deviation of the optimal mixture
is close to that of the random walk because the estimated weighting factor for the optimal mixture is close to
unity.
Figure 2.4 shows the mean and 90% confidence interval forecasts of the logarithmic value of USD S&P 500
based on the optimal mixture, random walk, and mean reversion models. Because the optimal mixture model
uses the mean forecasts of the mean reversion model, it is classified as a type of modified mean reversion
model. Actually, whether mean forecasts are selected from the random walk or the mean reversion model is
unimportant in long-horizon forecasting, because the deviation of today’s price from the long-term path is
dominated by the long-term path and its continuously increasing volatility.
One alternative choice in mean forecasting is to utilize current market data as an unbiased future expectation,
as we do in LongRun. LongRun broadly uses forward prices for mean forecasting, and implied volatilities
from option prices for volatility forecasting. However, the use of current market data in ClearHorizon is
restrictive because of the long horizon. To forecast interest rates and foreign exchange rates, we can use
implied forward interest rates and implied forward foreign exchange rates, which are calculated from current
yield curves and interest rate parity.
The size of the confidence interval of the optimal path is determined by the standard deviation forecasts and
has already been shown in Figure 2.4. Overall, the forecasted path and its confidence interval in the optimal
mixture take the golden mean of two extremes.
Since we assumed that the logarithm of the asset price pt follows a normal distribution,

pt+k ∼ N (µt+k , σt+k

2
), (2.13)

the asset price Pt follows the lognormal distribution.

Given the mean (µt+k ) and standard deviation (σt+k ) of the logarithm of the asset price, the mean [E(Pt+k )]
and upper and lower confidence intervals [U (Pt+k , α) and L(Pt+k , α)] of the asset price are calculated as

RiskMetrics
2.2. A HYBRID MODEL 11

Figure 2.3: Volatility Computed from the Optimal Mixture Model

Variance Ratio of USD S&P 500

1.2

0.8
variance ratio

0.6

0.4

0.2

0 20 40 60 80 100 120

Volatility of USD S&P 500

Random Walk
0.6 Actual Data
Optimal Mixture
0.5 Mean Reversion
volatility

0.4

0.3

0.2

0.1

0
0 20 40 60 80 100 120
time horizon, month

ClearHorizonTM Technical Document

12 CHAPTER 2. FORECASTING METHODOLOGY

Figure 2.4: Forecasts of the Optimal Mixture Model, Logarithm of Price

Forecasts of USD S&P 500 from May 2000

9.5
Random Walk
9

8.5
log price

7.5

7
−20 0 20 40 60 80 100 120

9.5
Optimal Mixture
9

8.5
log price

7.5

7
−20 0 20 40 60 80 100 120

9.5
Mean Reversion
9

8.5
log price

7.5

7
−20 0 20 40 60 80 100 120
time horizon, month
RiskMetrics
2.2. A HYBRID MODEL 13

 
σ2
E(Pt+k ) = exp µt+k + t+k , (2.14)
2

 
U (Pt+k , α) = exp µt+k + Zα σt+k , (2.15)

and

 
L(Pt+k , α) = exp µt+k − Zα σt+k , (2.16)

where Zα denotes the value of the standard normal distribution at (1 − α) significance (e.g., Z0.05 = 1.645).
Note that the mean [E(Pt+k )] of the asset price is determined by the standard deviation (σt+k ) as well as the
mean (µt+k ) of the logarithm of the asset’s price.
Figure 2.5 shows the mean and 90% confidence interval forecasts of the price of USD S&P 500 based on the
optimal mixture, random walk, and mean reversion models. Across these models, we can see a much larger
difference in the confidence intervals of prices than in the logarithms of the prices (Figure 2.4).

ClearHorizonTM Technical Document

14 CHAPTER 2. FORECASTING METHODOLOGY

Figure 2.5: Forecasts of the Optimal Mixture Model, Price

Forecasts of USD S&P 500 from May 2000

Random Walk
12000
10000
price

8000
6000
4000
2000
−20 0 20 40 60 80 100 120

Optimal Mixture
12000
10000
price

8000
6000
4000
2000
−20 0 20 40 60 80 100 120

Mean Reversion
12000
10000
price

8000
6000
4000
2000
−20 0 20 40 60 80 100 120
time horizon, month
RiskMetrics
Chapter 3

Forecasting Examples

3.1 Estimation of Parameters

In this chapter, we present 23 examples of asset price forecasting across several instruments: foreign ex-
change; short and long-term government bonds; the equity indices of Germany, Japan, Mexico, and the U.S.;
and the commodity prices of copper, WTI, heating oil, and gold. Generally, we estimated all three models
by utilizing month-end prices from January 1986 to April 2000. Because of data restrictions, the parameters
for DEM DAX, DEM 3M and 10Y T-bonds, JPY 3M and 10Y T-bonds, MXN FX, MXN IPC, and MXN 3M
and 1Y swaps are estimated with less than ten years of historical data. The estimated parameters in the three
models are shown in Table 3.1. Also, Figure 3.1 plots the variance ratios of the three models.
Parameter estimation results in very high fitness to data since the R 2 of the mean reversion model exceeds
0.9, except for the MXN 3M swap (0.87), MXN 1Y swap (0.89), WTI future (0.83), and Heating Oil
future (0.75). This means that more than 90% of the price movement is explained by the mean reversion
model. Furthermore, the mean reversion models of USD S&P 500, DEM DAX and 3M T-Bill, and MXN
FX show exceptionally high fitness to the data because the R 2 exceeds 0.99. Although the R 2 of the random
walk model is slightly lower than that of the mean reversion model, the random walk model still shows a
very high degree of fitness to the data. 1
It is worth noting that while all the equity indices and MXN FX have a strong time trend, almost all the
government bond yields lack a time trend (estimated β is near 0) and shrink to the Geometric Ornstein-
Uhlembeck (GOU) process. When we estimate the mean reversion equation, Equation 2.7, for the interest
rates, we need to remove the time-trend term for efficient estimation. 2
1 Since the number of unknown parameters in the mean reversion model is one more than in the random walk model, the R 2 of
the mean reversion model is usually higher than the R 2 of the random walk model.
2 In addition to efficient estimation, the GOU process is more reasonable for interest rate modeling from the theoretical point of
view because it is impossible for interest rates to maintain a strong time trend for a long period of time.

15
16 CHAPTER 3. FORECASTING EXAMPLES

Table 3.1: Estimation of Parameters

Random Walk Mean Reversion Optimal Mixture

Asset α σ α β γ σ ω
USD S&P 500 0.0113 0.0450 0.2524 0.0005 0.9536 0.0444 0.6857
USD Gov’t 3M -0.0020 0.0479 0.0204 0.0000 0.9842 0.0475 1.0000
USD Gov’t 1Y -0.0012 0.0556 0.0428 0.0000 0.9748 0.0552 1.0000
USD Gov’t 10Y -0.0025 0.0416 0.1862 -0.0002 0.9142 0.0407 0.3195
USD Gov’t 30Y -0.0032 0.0348 0.2169 -0.0003 0.9028 0.0339 0.2856
EUR FX 0.0008 0.0327 0.0146 -0.0001 0.9518 0.0318 0.7042
DEM DAX 0.0130 0.0582 0.2663 0.0005 0.9624 0.0575 0.9498
DEM Gov’t 3M -0.0076 0.0421 -0.0599 0.0005 1.0167 0.0411 0.0000
DEM Gov’t 1Y -0.0018 0.0644 0.0349 -0.0001 0.9807 0.0641 1.0000
DEM Gov’t 10Y -0.0023 0.0346 0.0794 -0.0001 0.9587 0.0343 1.0000
JPY FX -0.0019 0.0656 -0.8226 0.0003 0.9203 0.0631 1.0000
JPY Nikkei 0.0019 0.0656 0.8226 -0.0003 0.9203 0.0631 1.0000
JPY Gov’t 3M -0.0488 0.3979 0.5633 -0.0130 0.7273 0.3698 0.1466
JPY Gov’t 1Y -0.0210 0.2884 0.2149 -0.0022 0.9108 0.2816 0.3126
JPY Gov’t 10Y -0.0117 0.1295 0.3157 -0.0029 0.7980 0.1230 0.3268
MXN FX 0.0115 0.0540 0.0569 0.0005 0.9607 0.0535 1.0000
MXN IPC 0.0132 0.0959 1.4564 0.0031 0.8009 0.0907 0.2503
MXN Swap 3M -0.0028 0.1620 0.2066 -0.0004 0.9384 0.1592 1.0000
MXN Swap 1Y -0.0016 0.1398 0.1649 -0.0002 0.9503 0.1380 1.0000
Copper Spot 0.0003 0.0733 0.2888 0.0000 0.9616 0.0726 0.6740
WTI Future -0.0008 0.0979 0.2753 0.0000 0.9070 0.0955 0.2250
Heating Oil 0.0007 0.1088 0.5192 0.0001 0.8696 0.1052 0.1654
Gold -0.0015 0.0359 0.4723 -0.0002 0.9227 0.0350 0.3864

RiskMetrics
3.2. DEGREE OF MEAN REVERSION 17

3.2 Degree of Mean Reversion

How much of the mean reversion property does an individual asset’s price have? If either the estimated γ
of an asset price is close to 1 or the estimated ω is close to 1 (Table 3.1), the variance ratio of the optimal
mixture approaches or overlaps the variance ratio of the random walk, as shown in Figure 3.1.
Thus, the asset price has a weak mean reversion property or none at all. In our example, short-term interest
rates and foreign exchange rates show weak mean reversion. Specifically, the USD 3M and 1Y T-bonds;
the DEM 3M, 1Y, and 10Y T-bonds; JPY/USD Exchange, MXN/USD Exchange, and MXN 3M swap do
not show any mean reversion properties. In this case, the variance ratio of the optimal mixture overlaps the
variance ratio of the random walk, as shown in Figure 3.1.
If the estimated γ of an asset price is far less than 1 and its estimated ω is far less than 1 (see Table 3.1),
the variance ratio of the mean reversion model is far below that of the random walk model, and the variance
ratio of the optimal mixture model comes close to that of the mean reversion model, as shown in Figure 3.1.
Thus, the asset price has a strong mean reversion property. In our example, long-term interest rates and
commodity prices show strong mean reversion. Specifically, the USD 10Y and 30Y T-bonds, all maturities
of JPY T-bonds, WTI future, Heating Oil future, and Gold spot all show strong mean reversion properties.
In the case of stock market indices, the degree of mean reversion varies by index. While JPY Nikkei and
DEM DAX show no or very weak mean reversion, MXN IPC and USD S&P 500 show relatively strong
mean reversion.
Our results are consistent with previous empirical studies of the mean reversion model. Many of these
studies confirm strong mean reversion in long-term interest rates and commodity prices, but no or weak
mean reversion in short-term interest rates and foreign exchange rates.
As we discussed in the previous chapter, different degrees of mean reversion lead to totally different long-term
forecasts of the mean and confidence interval. We can use our observation of the degree of mean reversion
across asset prices to generate more robust forecasts. Since the process of generating forecasts, given our
estimated parameters, is tedious and lengthy, we omit it from this publication.

3.3 Additional Remarks

One of the most difficult aspects of long-term forecasting is the impossibility of implementing backtesting,
due to the many data and regime changes within the sample period. Similarly, in this version of ClearHorizon
we could not implement any backtesting to prove that our optimal mixture model, consisting of random walk
and mean reversion models, provides better forecasts than other models. Therefore, we are willing to use it
as is. We emphasize, however, the fact that the optimal mixture model is a best fit to the historical behavior
of any given asset’s price.

ClearHorizonTM Technical Document

18 CHAPTER 3. FORECASTING EXAMPLES

ClearHorizon is not a stand-alone methodology for the calculation of VaR beyond a two-year horizon. For
this special case, readers should consider ClearHorizon as an extension of LongRun. In most cases, the
framework of LongRun, such as correlation structure and Level 1 and Level 2 Simulation, can also be
implemented at horizons exceeding two years, without significant modification.

RiskMetrics
3.3. ADDITIONAL REMARKS 19

Figure 3.1: Variance Ratios

USD S&P 500 USD Government Zero 3M

1 3

2
0.5
1
0
0 20 40 60 80 100 120 0 20 40 60 80 100 120
USD Government Zero 1Y USD Government Zero 10Y

2
1
1.5

1 0.5
0.5
0
0
0 20 40 60 80 100 120 0 20 40 60 80 100 120
USD Government Zero 30Y EURO FX

1 1

0.5 0.5

0 0
0 20 40 60 80 100 120 0 20 40 60 80 100 120
DEM DAX DEM Government Zero 3M
6

1 4

0.5 2

0
0
0 20 40 60 80 100 0 20 40 60 80

ClearHorizonTM Technical Document

20 CHAPTER 3. FORECASTING EXAMPLES

Figure 3.1: Variance Ratios (continued)

DEM Government Zero 1Y DEM Government Zero 10Y

2.5
2
2
1.5
1.5
1
1
0.5
0.5
0
0 20 40 60 80 100 120 0 20 40 60
JPY FX JPY Nikkei 225
3 3

2 2

1 1

0 0
0 20 40 60 80 100 120 0 20 40 60 80 100 120
JPY Government Zero 3M JPY Government Zero 1Y

1 1

0.5 0.5

0 0
0 20 40 60 80 0 20 40 60 80 100 120
JPY Government Zero 10Y MXN FX

1.5
1
1
0.5
0.5
0
0
0 20 40 60 0 20 40 60

RiskMetrics
3.3. ADDITIONAL REMARKS 21

Figure 3.1: Variance Ratios (continued)

MXN IPC MXN Swap 3M

1 1.5

1
0.5
0.5
0
0
0 20 40 60 0 20 40 60
MXN Swap 1Y Copper Spot
2
1
1.5

1
0.5
0.5

0 0
0 20 40 60 0 20 40 60 80 100 120
WTI Future Heating Oil Future

1
1

0.5
0.5

0 0
0 20 40 60 80 100 120 0 20 40 60 80 100 120
Gold Spot

1 Random Walk
Actual Data
Optimal Mixture
0.5 Mean Reversion

0
0 20 40 60 80 100 120

ClearHorizonTM Technical Document

22 CHAPTER 3. FORECASTING EXAMPLES

RiskMetrics
Chapter 4

Applications of ClearHorizon

4.1 FortuneManagerTM

The RiskGradeTM statistic is a new measure of volatility recently devised by the RiskMetrics Group to help
investors better understand their market risk. RiskGrade measurements are based on the exact same data and
analysis as RiskMetrics® Value-at-Risk (VaR) estimates and, in fact, can be translated back into VaR estimates.
The RiskGrade measure, however, is scaled to be more intuitive and easier to use than VaR. RiskGradesTM are
measured on a scale from 0 to 1000 or more, where 100 corresponds to the average RiskGrade value of major
equity market indices during normal market conditions from 1995 to 1999. You would expect cash to have
a RiskGrade value of 0, while a technology IPO may have a RiskGrade value exceeding 1000.
The RiskGrade statistic is a good measure of risk. It is a representative and universal scaler of risk for all
types of investment instruments. However, for specific situations, such as a relatively longer investment
horizon, we need additional measurements in order to draw the whole picture of risk. For this purpose, the
RiskMetrics Group devised FortuneManagerTM to provide a simulation-based risk management tool for the
long-horizon investment needs of individual investors and financial advisory companies.
This section briefly introduces the architecture of FortuneManager to illustrate the application of ClearHorizon
forecasting methodology. FortuneManager consists of three engines: forecasting, simulation, and optimiza-
tion engines, as shown in Figure 4.1.

1. Forecasting Engine
This engine forecasts the price movements of risk factors and thus provides a means of generating
reasonable scenario simulations. Since the forecasting horizon must extend up to 50 years in order to
cover long-horizon goals (e.g., retirement funds), ClearHorizon is used as the forecasting methodology
by the engine.

23
24 CHAPTER 4. APPLICATIONS OF CLEARHORIZON

Figure 4.1: FortuneManager Flowchart

Input Engine Output

Asset Class Benchmark Index Expected Return and Standard Deviation

Equity US Large Cap S&P 500
USD S&P 500 Index Forecasting
US Mid Cap Russell Mid 10000
US Small Cap Russell 2000
International MSCI EAFE
Emerging IFCI Forecasting 1000
Fixed Income US Long-term TB/Corp 10yr - 0 12 24 36 48 60 72 84 96 108 120
US Mid-term TB/Corp 4-9
US Short-term TB/Corp 1-3 USD TB 10yr Yield Forecasting
8
US Municipal LB 20yr Muni Engine 6
US High Yield SB High Yield
4
International SB Non-US
2
Cash T-Bill 30 days
0 12 24 36 48 60 72 84 96 108 120
Real Estate REITs NAREIT All

Investor’s Information Mean and Probability of Shortfall for each goal

Personal Information
100
Goal 1: College USD 240,000 (before tax)
Age 30 yr
Income USD 60,000/yr 50
Shortfall
Current Asset USD 10,000
0
Tax Bracket 20% Simulation
160 224 288 352
Schedule
Saving1 USD 500/mo up to 15 yr
Goal 2: Retirement USD 1,000,000
Saving2 USD 750/mo from 16 to 35 yr 100

Goal 1 College USD 200,000 in 15 yr Engine 50 Shortfall

Goal 2 Retirement USD 1,000,000 in 35 yr 0
Asset Allocation Commission Fee 300 940 1580 2220
US Large Cap 75% 2.0%
US Long-term 25% 1.5% Year Mean Shortfall
Goal 1 Colleage 2020 309,154 4.5%
Goal 2 Retirement 2035 1,479,664 8.7%

Mean and Probability of Shortfall for each allocation

Goal 1: College Goal 2: Retirement
Alternative Asset Allocations mean shortfall mean shortfall
Aggressive 5 Small Cap 50 Mid Cap 50 Aggressive 5 497,896 3.3% 2,383,013 4.8%
Aggressive 4 Mid Cap 50 Large Cap 50 Aggressive 4 452,633 2.8% 2,166,376 4.0%
Aggressive 3 Mid Cap 25 Large Cap 75 Optimization Aggressive 3 411,485 2.3% 1,969,432 4.5%
Aggressive 2 Large Cap 95 Long-term 5 Aggressive 2 374,077 2.9% 1,790,393 5.6%
Aggressive 1 Large Cap 85 Long-term 15 Aggressive 1 340,070 3.6% 1,627,630 7.0%
Current Large Cap 75 Long-term 25 Current 309,154 4.5% 1,479,664 8.7%
Conservative 1 Large Cap 65 Long-term 35 Engine Conservative 1 278,239 5.4% 1,331,697 10.4%
Conservative 2 Large Cap 45 Long-term 55 Conservative 2 250,415 6.5% 1,198,528 12.5%
Conservative 3 Large Cap 20 Long-term 80 Conservative 3 225,374 7.8% 1,078,675 15.0%
Conservative 4 Long-term 80 Short-term 20 Conservative 3 202,836 9.3% 970,807 18.0%
Conservative 5 Long-term 50 Short-term 50 Conservative 4 182,553 11.2% 873,727 21.6%

RiskMetrics
4.1. FORTUNEMANAGERTM 25

The input to the forecasting engine consists of historical data for each benchmark index that the investor
chooses to represent each asset type in any given asset class (see Figure 4.1, upper left). The specified
asset classes must cover all of the investor’s asset allocation choices, and the benchmark index must
contain more than ten years of historical data.
The engine provides up to 50 years of monthly forecasts consisting of the mean and standard deviations
of asset prices or returns. These forecasts are used as inputs to the simulation engine for constructing
scenarios of the future. Investors can refer to the forecasts when they make asset allocation decisions.

2. Simulation Engine
The simulation engine generates scenarios of asset price movement and calculates the distribution of
portfolio values at each of the investor’s horizons. The distribution is summarized by two parameters:
the forecasted mean value (the return measure) and the probability of shortfall from a predetermined
goal (the risk measure). The probability of shortfall will be explained in detail in a later part of this
section. The simulation interval must be fixed to a monthly frequency to handle a monthly savings
schedule and near-future financial goals (e.g., down-payment for a new house in six months) as well
as long-horizon goals.
The investor needs to provide personal information (e.g., age, amount of current assets, and tax bracket),
a savings schedule, a multiple goals schedule, and asset allocation decisions. The tax, commission fee
for investment, and inflation are adjusted before and during simulation. 1
The simulation methodology of LongRun is used for this multi-period simulation engine. For a more
detailed discussion, refer to Chapter 5 of the LongRun Technical Document [4].

3. Optimization Engine
Because we provide simulation-based risk measures, it is impractical for us to construct a global
optimization engine to determine the investor’s best asset allocation strategy — the engine would
require excessively long computational time. Instead, we developed a simple and practical optimization
algorithm, the so-called pseudo-optimization engine, that is restricted to solving a local optimization
problem and involves computing incremental improvements in the investor’s current asset allocations.
Based on the investor’s current asset allocations, age, and risk tolerance level, the algorithm constructs
both more aggressive and more conservative asset allocations. The construction of good alternative
asset allocations is a key element in obtaining a reasonable optimization solution that comes close to
the global optimization solution. Thus, FortuneManager’s optimization engine provides an entire risk-
return profile of asset allocation alternatives. The investor can then choose the optimal asset allocation
scheme based on her risk-return preference (the so-called utility function).

1 While the commission fee is computed by applying a constant rate to the total amount of assets in each asset class, the future
inflation rate must be considered as another risk factor in the simulation.

ClearHorizonTM Technical Document

26 CHAPTER 4. APPLICATIONS OF CLEARHORIZON

Before concluding the discussion of FortuneManager, we define its risk measure, the probability of shortfall.
The probability of shortfall shows the probability with which the value of an investment at a predetermined
horizon can drop below the value that an investor predetermines as the goal.

We can calculate the probability of shortfall as

Z z
probability of shortfall = Prob[P&Lt,k < z] = f (xt,k )dx, (4.1)
−∞

where P&Lt,k = xt,k denotes the k-month P&L from time t, and f (·) is the P&L density function. Parameter
z is the goal value of the investment.

The accuracy of the probability of shortfall depends on the accuracy of the P&L density function. As we
described in the sections on forecasting and simulation engines, we construct the P&L density function for
each horizon by Monte Carlo simulation with ClearHorizon forecasts of the expected returns and volatilities
of the risk factors.

4.2 Pension Risk Management

ClearHorizon can be applied to any situation that requires the measurement of risk arising from long-term
fluctuations in market prices. One such situation is that of defined benefit pension plans, where the main
sources of risk are the long-term fluctuations in prices driving the value of the plan’s assets, and the discount
and inflation rates that determine the value of the liabilities. 2

The most relevant risk for defined benefit plans is funding risk; that is, the risk that the plan’s assets will be
insufficient to fund the liabilities at a long horizon. One might be tempted to quantify the funding risk of a
pension plan by projecting the value of the assets calculated from a random walk model; but given the mean
reverting nature of some assets (see Chapter 2), this approach is likely to overestimate the potential gains and
losses from the changes in asset prices. Under these circumstances, ClearHorizon’s optimal mixture model
can provide better estimates of the funding risk faced by the plan.

As an example, consider a defined benefit plan with a current funded ratio (the ratio of assets to liabilities)
of 100%. Suppose that the plan’s assets are allocated in the following way: 40% Lehmann Aggregate Bond
Index, 30% S&P 500, 15% Russell 2000, 10% MSCI EAFE, and 5% cash. Let us also make the simplifying
assumption that the annual benefits paid to retired employees and the annual contributions are equal to 6%
2 This section was written by Jorge Mina of RiskMetrics. He collaborated with J.P. Morgan Investment Management on the
development of PensionMetricsTM .

RiskMetrics
4.2. PENSION RISK MANAGEMENT 27

of the value of the liabilities. We set the initial discount rate to 7%, and, to simplify the exposition, we set
the normal cost of the plan at 8% of the value of the liabilities each year.3
Figure 4.2 compares 25 funded ratio paths generated by using a random walk and ClearHorizon’s optimal
mixture model. The paths generated from the random walk model show unreasonably high funded ratios,
which arise from the fast increase in variance, while the paths generated from the mixture model seem quite
reasonable given that the data used to estimate the model was taken from a bull market period (monthly
returns for the last ten years).
Figure 4.3 shows the distribution of the funded ratio at the end of ten years. The distribution is obviously
bounded at zero and also skewed mainly because of the large expected returns from the assets. The median
of the distribution corresponds to a funded ratio of 150%. We can also observe that with a probability of
95%, the pension plan will not be underfunded after ten years. There is also a 1% probability that the funded
ratio will end below 90% after ten years.
By repeating this exercise with different asset allocations and looking at the funding risk exposure of each
allocation, a pension plan can improve its investment decisions.
The example in this section shows an application of the optimal mixture model to estimating the funding
risk of a defined benefit pension plan. The long-term risks of the plan are assessed by using a model that
incorporates the mean reversion property of asset prices and, hence, keeps their variances from blowing up.
As the example shows, ClearHorizon’s optimal mixture model presents a more realistic picture of long-term
risk than the alternative random walk model.

3 The normal cost is the present value of the increase in accrued benefits from year to year. Normal cost is one of the factors that
increases liabilities from year to year; the other factor is the effect of the compound interest on the liabilities.

ClearHorizonTM Technical Document

28 CHAPTER 4. APPLICATIONS OF CLEARHORIZON

Figure 4.2: Funded Ratio over the Next Ten Years

Random Walk
1000

800
Funded Ratio

600

400

200

0
1 2 3 4 5 6 7 8 9 10 11
Years

Optimal Mixture
300

250
Funded Ratio

200

150

100

50
1 2 3 4 5 6 7 8 9 10 11
Years

RiskMetrics
4.2. PENSION RISK MANAGEMENT 29

Figure 4.3: Distribution of the Funded Ratio Ten Years from Now

400

350

300

250

200

150

100

50

0
50 100 150 200 250 300 350
Funded Ratio

ClearHorizonTM Technical Document

30 CHAPTER 4. APPLICATIONS OF CLEARHORIZON

RiskMetrics
Bibliography

[1] Cochrane, John H. (1991) A Critique of the Application of Unit Root Tests, Journal of Economic
Dynamics and Control, Vol. 15, pp. 275–284.

[2] Glen, Jack D. (1992) Real Exchange Rates in the Short, Medium, and Long Run, Journal of International
Economics, Vol. 33, pp. 147–166.

[3] Hamilton, James D. (1994) Time Series Analysis, Princeton, New Jersey: Princeton University Press.

[4] Kim, Jongwoo, Allan M. Malz, Jorge Mina (1999) LongRun Technical Document, RiskMetrics Group,
New York.

[5] Metcalf, Gilbert E., Kevin A. Hassett (1995) Investment under Alternative Return Assumptions Com-
paring Random Walks and Mean Reversion, Journal of Economic Dynamics and Control, Vol. 19,
pp. 1471–1488.

[6] Morgan Guaranty Trust Company (1996) RiskMetrics Technical Document, 4th ed., New York.

[7] Wu, Yangru, Hua Zhang (1996) Mean Reversion in Interest Rates: New Evidence from a Panel of
OECD Countries, Journal of Money, Credit, and Banking, Vol. 28, pp. 604–621.

31