Simple Processes and the Pricing and Hedging of Cliquets

19 Pages Posted: 10 Jan 2013

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland

Wim Schoutens

KU Leuven - Department of Mathematics

Date Written: January 2013

Abstract

For data on market prices for 246 cliquets we consider pricing these exotic options using a relatively simple path space. The path space is subsequently stressed to market implied stress levels as well as stress levels predicted from contract characteristics. 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 permitting a 10% reduction in ask prices.

Keywords: Levy process, Sato process, pricing to acceptability

Suggested Citation

Madan, Dilip B. and Schoutens, Wim, Simple Processes and the Pricing and Hedging of Cliquets (January 2013). Mathematical Finance, Vol. 23, Issue 1, pp. 198-216, 2013, Available at SSRN: https://ssrn.com/abstract=2198771 or http://dx.doi.org/10.1111/j.1467-9965.2011.00485.x

Dilip B. Madan (Contact Author)

University of Maryland

Wim Schoutens

KU Leuven - Department of Mathematics ( email )

Celestijnenlaan 200 B
Leuven, B-3001
Belgium

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