ERM-602-12: Investment Management for Insurers - Ch.11: The Four Faces of an Interest Model



Reading Source: ERM-602-12 Study Note

Topics Covered in this Reading:

  • Categorization of Approaches to Term Structure Modeling
  • Equilibrium Modeling
  • Risk Neutral Probabilities: The Derivative Pricing Probability Measure
  • Realistic Probabilities: The Estimated Market Probability Measure
  • When Do I Use Each of the Modeling Approaches?
    • Risk Neutral and Arbitrage Free
    • Risk Neutral and Equilibrium
  • Using Models of Borrower Behavior with a Risk Neutral Interest Rate Model
    • Realistic and Arbitrage Free
    • Realistic and Equilibrium
  • Summary of the Four Faces


Can someone highlight the key points in this reading? Or simplify the reading so it is easier to understand? I’m having trouble understanding this reading and how it applies to ERM.

Separately, can someone please explain the difference between risk-neutral and real-world pricing? I understand that risk-neutral is used for derivative pricing and uses risk-free rate while real-world does not. I’m just confused about why we wouldn’t always use “real-world” rates?



Hi Beyoncepadthai,

You may want to check out this short article, it really helps explain (in simple terms) why we use risk-neutral probabilities for pricing :slight_smile:


Hi, I have the same question as @beyoncepadthai

What exactly is the point of this reading? Is anyone able to provide some background information that will help this reading make some more sense?

Id really like to “talk through the reading”