Simple Processes and the Pricing and Hedging of Cliquets
21 Pages Posted: 3 Feb 2010 Last revised: 3 May 2010
Date Written: February 2, 2010
Abstract
For data on market prices on 246 cliquets we consider the task of pricing these exotic options using a relatively simple path space subsequently stressed to market implied and then predicted stress levels. An additive process transitioning from a Sato process to a Levy process is formulated and estimated on vanilla options. Ask prices constructed from predicted stress levels are observed to have an in sample correlation of 92% with market prices. Interestingly, it is observed that capped cash flows have negative stress levels while uncapped products have positive stress levels. We illustrate the effect of hedging cliquet liabilities using call options as hedging assets permiting a 10% reduction in ask prices.
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