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Valuation of Conditional Pension Liabilities and Guarantees under Sponsor Vulnerabilities

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  • Dirk Broeders
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    Abstract

    This paper analyzes the relationship between a pension fund with conditionally indexed de.ned benefit liabilities and its sponsor, using contingent claims analysis. As pension funds run a mismatch risk, future surpluses and shortfalls will occur. Surpluses are divided between beneficiaries and sponsor through conditional indexation and refunding. Covering an eventual loss at the pension fund level is a function of the sponsor's financial ability to do so. This paper suggests that this system creates an asymmetric allocation of the residual risk between sponsor and beneficiaries. The main conclusion is that the sponsor's vulnerability negatively impacts the optimum risk profile of a defined benefit scheme with conditional indexation and thereby the market value of conditional indexation.

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    File URL: http://www.dnb.nl/binaries/Working%20Paper%2082_tcm46-146739.pdf
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    Bibliographic Info

    Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 082.

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    Date of creation: Jan 2006
    Date of revision:
    Handle: RePEc:dnb:dnbwpp:082

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    Related research

    Keywords: De.ned bene.t; pension put; conditional indexation; vulnerable options;

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    1. Lo, Andrew W & Wang, Jiang, 1995. " Implementing Option Pricing Models When Asset Returns Are Predictable," Journal of Finance, American Finance Association, vol. 50(1), pages 87-129, March.
    2. Hull, John & White, Alan, 1995. "The impact of default risk on the prices of options and other derivative securities," Journal of Banking & Finance, Elsevier, vol. 19(2), pages 299-322, May.
    3. Blake, David, 1998. "Pension schemes as options on pension fund assets: implications for pension fund management," Insurance: Mathematics and Economics, Elsevier, vol. 23(3), pages 263-286, December.
    4. Ponds, E.H.M., 2003. "Pension funds and value-based generational accounting," Open Access publications from Tilburg University urn:nbn:nl:ui:12-347898, Tilburg University.
    5. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
    6. Johnson, Herb & Stulz, Rene, 1987. " The Pricing of Options with Default Risk," Journal of Finance, American Finance Association, vol. 42(2), pages 267-80, June.
    7. Frank de Jong, 2005. "Valuation of pension liabilities in incomplete markets," DNB Working Papers 067, Netherlands Central Bank, Research Department.
    8. Fischer, Stanley, 1978. "Call Option Pricing when the Exercise Price Is Uncertain, and the Valuation of Index Bonds," Journal of Finance, American Finance Association, vol. 33(1), pages 169-76, March.
    9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    10. Cui, Jiajia & Jong, Frank De & Ponds, Eduard, 2011. "Intergenerational risk sharing within funded pension schemes," Journal of Pension Economics and Finance, Cambridge University Press, vol. 10(01), pages 1-29, January.
    11. Klein, Peter, 1996. "Pricing Black-Scholes options with correlated credit risk," Journal of Banking & Finance, Elsevier, vol. 20(7), pages 1211-1229, August.
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