Løchte, Peter () (Department of Business Studies, Aarhus School of Business)
Abstract
This paper introduces, prices, and analyzes traffic light options. The traffic light
option is an innovative structured OTC derivative developed independently by several
London-based investment banks to suit the needs of Danish life and pension (L&P)
companies, which must comply with the traffic light solvency stress test system introduced by the Danish Financial Supervisory Authority (DFSA) in June 2001. This monitoring system requires L&P companies to submit regular reports documenting the sensitivity of the companies’ base capital to certain pre-defined market shocks – the red and yellow light scenarios. These stress scenarios entail drops in interest rates as well as in stock prices, and traffic light options are thus designed to pay off and preserve sufficient capital when interest rates and stock prices fall simultaneously. Sweden’s FSA implemented a traffic light system in January 2006, and supervisory authorities in many other European countries have implemented similar regulation. Traffic light options are therefore likely to attract the attention of a wider audience of pension fund managers in the future. Focusing on the valuation of the traffic light option we set up a Black-Scholes/Hull-White model to describe stock market and interest rate dynamics, and analyze the traffic light option
in this framework.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
Publisher Info
Paper provided by University of Aarhus, Aarhus School of Business, Department of Business Studies in its series Finance Research Group Working Papers with number
F-2006-08.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.: