Risk Modeling and Validation of Custom Asset Classes

This technical report presents a methodology for validating custom risk-neutral asset classes within the GEMS® Economic Scenario Generator. The report outlines the calibration of native equity asset classes to observed equity option prices and the need for modeling additional indices like EAFE and MSCI EM. It details the construction of a custom risk-neutral asset class using the Russell 2000 index, including regression analysis on historical price returns to develop model parameters. The report describes the implementation of this model in GEMS, adhering to specific rules for creating custom asset classes. It also compares the Martingale test results of the native Small Cap asset class with the newly developed RTY return class, noting significant differences in results. Furthermore, the report evaluates option pricing tests, indicating that the simulated prices align closely with observed market prices, achieving a high r-squared value. The findings suggest that the calibrated return class is a viable approach for asset classes lacking option prices.