Cass Undergraduate School

BSc (Hons) Degree in Actuarial Science

BSc (Hons) Degree in Mathematical Science

AS2204 Stochastic Models [CT4a]

Part of Subject CT4 of the Institute and Faculty of Actuaries Examinations
Part 2 Examination

17th January 2014 10:00-12:15

Instructions to students:

Candidates should answer ALL FOUR questions from Section A, plus any TWO of the
FOUR questions from Section B. Candidates should begin each question on a new
sheet of paper.

The number of marks allocated is shown at the end of each question. Where marks have
been quoted for parts of questions, these are intended to be a helpful quide to the
candidates.

This examination paper consists of 6 printed pages excluding the title page.

Materials:

Number of answer books to be provided: 1

Only the Casio calculators FX-83 (MS, ES or GT+) or FX-85 (MS, ES or GT+) are
permitted for use in this exam
Dictionaries are not permitted.
This examination paper may be removed from the examination room.

External Examiner: Prof Jian Zhang

Internal Examiner: Dr Russell Gerrard
 Important note for students regarding past exam papers
Past exam papers are published for illustrative purposes only. They can be used as a study
aid but do not provide a definitive guide to either the format of the next exam, the topics that
will be examined or the style of questions that will be set. Students should not expect their
own exam to be directly comparable with previous papers. Remember that a degree
requires an amount of self-study, reading around topics, and lateral thinking – particularly at
the higher level modules and for higher marks. Specific guidance for your exam will be given
by the lecturer.
 SECTION A: Compulsory questions

QUESTION 1
A Markov chain on state space S = {1, 2, 3, 4, 5} has transition diagram as shown below.
a
1 2

a a
a
a 3 b b
a
a b
4 5
b
(i) Evaluate a and b. [1 mark]
(ii) (a) Explain what it means to say that one state communicates with another.
(b) Show that communication is an equivalence relation. [4 marks]
(iii) Divide the state space S into communicating classes, stating, for each class, whether it
is transient or recurrent. [3 marks]
[Total: 8 marks]

QUESTION 2
When an advertisement for a new gadget appears, it takes a consumer an average of 2 days
to see the advert. With probability 20% the consumer’s first response is to decide he wants
to buy the gadget; with probability 30% he decides not to buy it; otherwise he is undecided.
If he is initially undecided, he remains undecided for an average of 20 days, after which he is
equally likely to decide in favour of buying it or against buying it.
This situation is to be modelled as a Markov Jump process, with states
A : has not yet seen the advertisement
B : has not decided whether to buy
C : has decided to buy the gadget
D : has decided not to buy the gadget
(i) Write down the generator matrix, Q, of this process. [2 marks]
(ii) Calculate the probability that the consumer decides to buy the gadget. [1 mark]
(iii) Explain why the transition probability pAB (t) satisfies the equation
Z t
pAB (t) = λA e−λA u × rAB × pBB (t − u) du.
0

Your explanation should include definitions of the terms λA and rAB . [2 marks]
(iv) What is the probability that, 10 days after the advert appears, the consumer has not
yet made up his mind whether to buy the gadget? [4 marks]
[Total: 9 marks]
Page 1 of 6
QUESTION 3
US gasoline prices are reported monthly from January 2009, when the price was 45c per
litre, to November 2013, when it was 87.4c per litre. The sample mean of the 58 monthly
price increments (measured in cents) was 0.7293, sample standard deviation 4.46. (Source:
U.S Energy Information Administration.) The gasoline price process is to be modelled as a
random walk.

(i) (a) Calculate estimates of the mean and variance of the price of gasoline in December
2014.
(b) Write down, in terms of the standard Normal distribution function Φ, an estimate
of the probability that gasoline will cost less than 80c per litre in December 2014.
(You may assume that, as the price of gasoline tends to infinity, the probability
of ever returning to 80c per litre approaches 0.) [4 marks]

(ii) The data set is discretised by rounding off the prices to the nearest multiple of 10c. In
the 58 monthly increments there were 13 months when the price increased by 10c, 9
months when it decreased by 10c and 36 months when it was unchanged.

(a) Estimate the probability that the discretised gasoline price series will, at some
time after November 2013, fall to 80c per litre.
(b) Give one reason why, even without doing any calculations, you might expect the
probability in (i)(b) to be smaller than that in (ii)(a).

[5 marks]

[Total: 9 marks]

QUESTION 4
An Excel spreadsheet contains, in cells A4:A100, a collection of pseudo-random numbers
uniformly distributed on (0, 1) and a starting value of 3 in cell B3. Cell B4 contains the
formula

=IF(B3=10,9,IF(B3=0,0,IF(A4<0.5,B3+1,B3-1))),

which is then copied down into cells B5:B100.

(i) Describe the process which is being simulated in column B. [2 marks]

(ii) Write down the value which is most likely to appear in cell B100, giving a reason for
your answer. [2 marks]

[Total: 4 marks]

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 SECTION B: Optional questions

QUESTION 5

(i) You are given a sequence of pseudo-random numbers from the range (0, 1):

0.8724 0.3391 0.2473 0.4083 0.1295

Use these numbers to simulate a Poisson process with rate parameter λ = 3 from time
0 to time 1. Draw a graph of the simulated process from time 0 to time 1. [4 marks]

(ii) A surplus process, {S(t) : t ≥ 0} is defined by

N (t)
X
S(t) = u + ct − Yj ,
j=1

where u and c are constants, N (t) is a standard Poisson process with rate λ = 3 and
{Yj : j = 1, 2, . . .} is a sequence of independent, identically distributed discrete random
variables with unknown distribution.
An observer makes a note of the value of S(t) before and after every jump which takes
place during the time interval from t = 0 to t = 2:
Time 0.70 0.95 0.98 1.08 1.46 1.79
Jump 470 → 430 505 → 305 314 → 274 304 → 264 378 → 338 437 → 237

(a) Sketch a graph of the process S(t) from t = 0 to t = 2.

(b) Calculate the values of the constants u and c.
(c) Write down the value of the surplus process at time 2.
(d) Derive an estimate of the probability function of the random variables Yj .
(e) Assuming that the probability function of the Yj is equal to the estimate in (d),
evaluate the probability that S(2.5) > 350.

[11 marks]

[Total: 15 marks]

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QUESTION 6
An archaeologist in Central America has discovered a new pyramid, with a four-sided base.
She draws a plan of the pyramid, labelling the sides of the base 1, 2, 3 and 4, and assigning
the label 0 to the top of the pyramid. When exploring it, she spends one hour in one of the
five locations, then moves on; if the location is 1, 2, 3 or 4, she moves to the next side around
the base with probability 0.9 (that is, from 1 to 2, from 2 to 3, from 3 to 4 or from 4 to 1),
or otherwise she climbs to the top; after an hour at the top, she comes down and chooses one
of the sides at random.
Let Xn denote her location n hours after starting the investigation.

(i) Explain why {Xn : n ≥ 0} is a Markov chain. [1 mark]

(ii) Write down the transition matrix. [2 marks]

(iii) Show that the Markov chain is ergodic. [2 marks]

(iv) Calculate the equilibrium distribution, π, of the Markov chain. (You may make use of
an argument based on symmetry if you state it clearly.) [4 marks]

(v) (a) Define the terms stationary process and process with stationary increments.
(b) Show that, if X0 is chosen randomly with distribution π, then {Xn : n ≥ 0} is a
stationary process.
(c) Under these circumstances, does the process possess stationary increments? Give
a reason for your answer.
[6 marks]

[Total: 15 marks]

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QUESTION 7
A body which regulates amateur football has a list of referees, who are classed as Category 1
(the highest level), Category 2, Category 3 or Retired. The regulatory body has decided to
fit a time-homogeneous Markov jump process (MJP) model to model the transitions between
categories. Based on past data, the best fitting generator matrix is
 
−0.21 0.01 0 0.2
 0.4 −0.57 0.02 0.15 
Q̂ =   per year.
 0 0.5 −0.6 0.1 
0 0 0 0

(i) Suggest one reason why the regulatory body might be interested in formulating a model
and fitting it to the data. [1 mark]

(ii) The sample used to fit the generator matrix included 30 Category 3 referees. Explain
how the third row of Q was arrived at, and derive the values of the quantities used in
the estimation procedure. [3 marks]

(iii) Calculate, according to the fitted model,

(a) the average time a referee spends in Category 3 before either retiring or moving
to Category 2;
(b) the probability that a referee who is moved out of Category 2 is demoted to
Category 3. [2 marks]

(iv) According to the MJP model, what is the distribution of time spent in Category 1
before leaving? Suggest how you might use this fact to test the goodness of fit of the
model to the data. [3 marks]

(v) The regulatory body has analysed the number of years spent in Category 2 according
to the age at which the referee was first appointed to Category 2, with the following
results:

Age on arrival
18–24 25–34 35–44
0–1.49 12 12 6
Years 1.5–3 24 18 8
>3 14 20 11

(a) What aspect of the model would be tested by a contingency table analysis of these
data?
(b) Carry out an appropriate test at the 5% level of significance, making sure that
you state your null and alternative hypotheses. (Note: χ24,0.05 = 9.49.)

[6 marks]

[Total: 15 marks]

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QUESTION 8
α-particles arrive at a Geiger counter according to a time-inhomogeneous Poisson process
with rate λ(t). The Geiger counter has a fault — whenever a particle is detected there is a
probability of 14 that the counter resets itself to 0; otherwise it simply adds 1 to the count.
Denote by X(t) the number showing on the counter at time t.

(i) Let p0j (0, t) denote the transition probability P(X(t) = j|X(0) = 0).

(a) Write down the Kolmogorov Forward Equation (KFE) satisfied by p0j (0, t), dis-
tinguishing between the case j = 0 and the case j > 0.
(b) Use the integrating factor method to show that the solution for j = 0 is
 Z t 
1 3
p00 (0, t) = + exp − λ(u) du .
4 4 0

[7 marks]

(ii) Let X̂n denote the jump chain of the process X(t), i.e., X̂n is the value showing on the
counter just after the nth α-particle is detected.

(a) Explain why the transition matrix, P , of X̂ is

 1 3 
4 4
0 ···
 1 0 3 ··· 
P =  41 0 04 · · · .
 
 4 
.. .. .. . .
. . . .

(b) State the Chapman-Kolmogorov equations as they apply to a discrete-time Markov

chain.
(c) Derive from the Chapman-Kolmogorov equations an expression in terms of P for
the n-step transition matrix P (n) .
(d) Calculate P(X̂5 = 1|X̂2 = 2).
(e) Discuss how you could determine P(X̂n = 1|X̂2 = 2) for all n > 2. [You may, if
you wish, assume that the eigenvalues and eigenvectors of P are supplied: you are
not expected to evaluate them yourself if your method involves the diagonalisation
of P .]

[8 marks]

[Total: 15 marks]

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