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Pricing the Option to Surrender in Incomplete Markets

  • Andrea Consiglio
  • Domenico De Giovanni

New international accounting standards require insurers to reflect the value of embedded options and guarantees in their products. Pricing techniques based on the Black and Scholes paradigm are often used; however, the hypotheses underneath this model are rarely met. We propose a framework that encompasses the most known sources of incompleteness. We show that the surrender option, joined with a wide range of claims embedded in insurance contracts, can be priced through our tool, and deliver hedging portfolios to mitigate the risk arising from their positions. We provide extensive empirical analysis to highlight the effect of incompleteness on the fair value of the option. Copyright (c) The Journal of Risk and Insurance, 2010.

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Article provided by The American Risk and Insurance Association in its journal Journal of Risk and Insurance.

Volume (Year): 77 (2010)
Issue (Month): 4 ()
Pages: 935-957

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Handle: RePEc:bla:jrinsu:v:77:y:2010:i:4:p:935-957
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  1. Grosen, Anders & Lochte Jorgensen, Peter, 2000. "Fair valuation of life insurance liabilities: The impact of interest rate guarantees, surrender options, and bonus policies," Insurance: Mathematics and Economics, Elsevier, vol. 26(1), pages 37-57, February.
  2. Moore, Kristen S. & Young, Virginia R., 2003. "Pricing equity-linked pure endowments via the principle of equivalent utility," Insurance: Mathematics and Economics, Elsevier, vol. 33(3), pages 497-516, December.
  3. Antonio S. Mello & John E. Parsons, 1995. "Maturity Structure Of A Hedge Matters: Lessons From The Metallgesellschaft Debacle," Journal of Applied Corporate Finance, Morgan Stanley, vol. 8(1), pages 106-121.
  4. Kjetil Høyland & Stein W. Wallace, 2001. "Generating Scenario Trees for Multistage Decision Problems," Management Science, INFORMS, vol. 47(2), pages 295-307, February.
  5. Anand, Amber & Tanggaard, Carsten & Weaver, Daniel G., 2009. "Paying for Market Quality," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(06), pages 1427-1457, December.
  6. David C. Porter & Carsten Tanggaard & Daniel G. Weaver & Wei Yu, 2008. "Dispersed Trading and the Prevention of Market Failure: the Case of the Copenhagen Stock Exchange," European Financial Management, European Financial Management Association, vol. 14(2), pages 243-267.
  7. Weiyu Kuo & Chenghsien Tsai & Wei-Kuang Chen, 2003. "An Empirical Study on the Lapse Rate: The Cointegration Approach," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 70(3), pages 489-508.
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