Simple Processes and the Pricing and Hedging of Cliquets

21 Pages Posted: 3 Feb 2010 Last revised: 3 May 2010

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Wim Schoutens

KU Leuven - Department of Mathematics

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.

Suggested Citation

Madan, Dilip B. and Schoutens, Wim, Simple Processes and the Pricing and Hedging of Cliquets (February 2, 2010). Robert H. Smith School Research Paper No. RHS 06-111, Available at SSRN: https://ssrn.com/abstract=1546363 or http://dx.doi.org/10.2139/ssrn.1546363

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

Wim Schoutens

KU Leuven - Department of Mathematics ( email )

Celestijnenlaan 200 B
Leuven, B-3001
Belgium

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