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Pricing Perpetual Fund Protection with Withdrawal Option

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  • Hans Gerber
  • Elias Shiu

Abstract

Consider an American option that provides the amountif it is exercised at time t, t ≥0. For simplicity of language, we interpret S1(t) and S2(t) as the prices of two stocks. The option payoff is guaranteed not to fall below the price of stock 1 and is indexed by the price of stock 2 in the sense that, if F(t) > S1(t), the instantaneous growth rate of F(t) is that of S2(t). We call this option the dynamic fund protection option. For the two stock prices, the bivariate Black-Scholes model with constant dividend-yield rates is assumed. In the case of a perpetual option, closed-form expressions for the optimal exercise strategy and the price of the option are given. Furthermore, this price is compared with the price of the perpetual maximum option, and it is shown that the optimal exercise of the maximum option occurs before that of the dynamic fund protection option.Two general concepts in the theory of option pricing are illustrated: the smooth pasting condition and the construction of the replicating portfolio. The general result can be applied to two special cases. One is where the guaranteed level S1(t) is a deterministic exponential or constant function. The other is where S2(t) is an exponential or constant function; in this case, known results concerning the pricing of Russian options are retrieved. Finally, we consider a generalization of the perpetual lookback put option that has payoff [F(t) − κS1(t)], if it is exercised at time t. This option can be priced with the same technique.

Suggested Citation

  • Hans Gerber & Elias Shiu, 2003. "Pricing Perpetual Fund Protection with Withdrawal Option," North American Actuarial Journal, Taylor & Francis Journals, vol. 7(2), pages 60-77.
    • Handle: RePEc:taf:uaajxx:v:7:y:2003:i:2:p:60-77
    DOI: 10.1080/10920277.2003.10596087
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    Citations

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    Cited by:

    1. Wong, Hoi Ying & Chan, Chun Man, 2007. "Lookback options and dynamic fund protection under multiscale stochastic volatility," Insurance: Mathematics and Economics, Elsevier, vol. 40(3), pages 357-385, May.
    2. Cheung, Ka Chun & Yang, Hailiang, 2005. "Optimal stopping behavior of equity-linked investment products with regime switching," Insurance: Mathematics and Economics, Elsevier, vol. 37(3), pages 599-614, December.
    3. Moore, Kristen S., 2009. "Optimal surrender strategies for equity-indexed annuity investors," Insurance: Mathematics and Economics, Elsevier, vol. 44(1), pages 1-18, February.
    4. Linyi Qian & Zhuo Jin & Wei Wang & Lyu Chen, 2018. "Pricing dynamic fund protections for a hyperexponential jump diffusion process," Communications in Statistics - Theory and Methods, Taylor & Francis Journals, vol. 47(1), pages 210-221, January.
    5. Chu, Chi Chiu & Kwok, Yue Kuen, 2004. "Reset and withdrawal rights in dynamic fund protection," Insurance: Mathematics and Economics, Elsevier, vol. 34(2), pages 273-295, April.
    6. Jun Sekine, 2012. "Long-term optimal portfolios with floor," Finance and Stochastics, Springer, vol. 16(3), pages 369-401, July.
    7. Han, Heejae & Jeon, Junkee & Kang, Myungjoo, 2016. "Pricing chained dynamic fund protection," The North American Journal of Economics and Finance, Elsevier, vol. 37(C), pages 267-278.
    8. Zhou, Jiang & Wu, Lan, 2015. "The time of deducting fees for variable annuities under the state-dependent fee structure," Insurance: Mathematics and Economics, Elsevier, vol. 61(C), pages 125-134.
    9. Ko, Bangwon & Shiu, Elias S.W. & Wei, Li, 2010. "Pricing maturity guarantee with dynamic withdrawal benefit," Insurance: Mathematics and Economics, Elsevier, vol. 47(2), pages 216-223, October.
    10. Gerber, Hans U. & Shiu, Elias S.W. & Yang, Hailiang, 2012. "Valuing equity-linked death benefits and other contingent options: A discounted density approach," Insurance: Mathematics and Economics, Elsevier, vol. 51(1), pages 73-92.

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