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Valuation of Conditional Pension Liabilities and Guarantees under Sponsor Vulnerabilities

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  • Dirk Broeders

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.

Suggested Citation

  • Dirk Broeders, 2006. "Valuation of Conditional Pension Liabilities and Guarantees under Sponsor Vulnerabilities," DNB Working Papers 082, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:082
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    File URL: https://www.dnb.nl/binaries/Working%20Paper%2082_tcm46-146739.pdf
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    References listed on IDEAS

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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.
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    3. Klein, Peter, 1996. "Pricing Black-Scholes options with correlated credit risk," Journal of Banking & Finance, Elsevier, vol. 20(7), pages 1211-1229, August.
    4. 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 637-654, May-June.
    5. 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.
    6. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    7. 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 169-176, March.
    8. 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.
    9. Ponds, Eduard H. M., 2003. "Pension funds and value-based generational accounting," Journal of Pension Economics and Finance, Cambridge University Press, vol. 2(03), pages 295-325, November.
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    Cited by:

    1. Jacob A. Bikker & Dirk W.G.A. Broeders & Dirk Jan de Dreu, 2010. "Stock Market Performance and Pension Fund Investment Policy: Rebalancing, Free Float, or Market Timing?," International Journal of Central Banking, International Journal of Central Banking, vol. 6(2), pages 53-79, June.
    2. J. de Dreu & J.A. Bikker, 2009. "Pension fund sophistication and investment policy," Working Papers 09-13, Utrecht School of Economics.

    More about this item

    Keywords

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

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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