Dynamic (Financial) Analysis

One of my research interests involves a process referred to in the actuarial profession and insurance industry as "dynamic financial analysis" (DFA). DFA emerged a decade or so ago as an approach to integrate the analysis of both the underwriting and financial (or liability and asset) sides of an insurer, and to recognize their interrelationships. It has now largely evolved into an analytical tool within another research interest, enterprise risk management (ERM) -- DFA can help to understand and quantify the impact on a company of risks viewed in an enterprise-wide or holistic framework.

In general, DFA treats the emergence of economic and financial variables as stochastic (and usually projects future values of those variables via Monte Carlo or other simulation techniques). Another approach is the testing of specific, hypothesized future scenarios. But internal consistency is important. For example, while it's possible to change just one variable at a time, and leave the others static or unchanged (ceteris paribus, in latin), such a scenario may not be reasonable -- a change in one variable may generally be associated with a change in another variable (through causation or just simple correlation).

The U.S. Department of the Treasury has recently issued a report titled "A Dynamic Analysis of Permanent Extension of the President's Tax Relief." This represents a new type of analysis -- dynamic as opposed to the historical static -- of tax policy. A quote from the Executive Summary:

Dynamic analysis goes beyond traditional analysis of tax policy by focusing on the broad economic effects in both the short and long term. Simply, dynamic analysis provides a more comprehensive and complete approach to analyzing tax policy by including its effects on the overall size of the economy and other major macroeconomic variables. The President’s FY 2007 Budget proposes to create a division of dynamic analysis within the Department of Treasury’s Office of Tax Analysis.

A nice start down the D(F)A road.

- Rick