p. 1/4
Outline
Introduction
Dealing with embedded options
Hedging: Some practical spects
The Guaranteed Minimum Withdrawal Benefit(GMWB)
Basic features
Valuation of basic GMWB contract
Semi static hedging
Concluding remarks
p. 2/4
p. 3/4
p. 4/4
Ways to Hedge
Buy options from another institution
Can be expensive, Lapses
Farm out hedging to a third party
Set up managed account.
Hedge in house
Keeps control. Need resources. Hedging
program can become politicized
p. 5/4
p. 6/4
p. 7/4
Features of DH
Does not protect against model risk
Suppose market jumps. Gives rise to gap risk
DH does not work if markets are closed for
some reason eg post nine eleven.
DH can be a challenge if gamma changes
sign frequently (cliquet options)
Dynamic hedging assumes you know the model,
continuous prices, that markets are open and
there is enough liquidity.
p. 8/4
p. 9/4
SSH Formula
Let Vt (St , T ) be market price at time t, of long
option to be hedged. We have (Carr Wu)
(1)
Vt (St , T ) =
k=0
p. 10/4
SSH Formula
The coefficients g are given by
2 V (S, , T )
g(k) =
|S=k
2
S
These correspond to the gammas of the long
term derivative at the horizon time with stock
price equal to k. Can approximate this integral
with a finite sum.
p. 11/4
GMWB
GMWB adds a guaranteed floor of withdrawal
benefits to a VA
Provides a guaranteed level of income to the
policyholder.
Suppose investor puts $100,000 in a VA
Policyholder can withdraw a certain fixed
percentage every year until the initial
premium is withdrawn
p. 12/4
GMWB
Assume the withdrawal rate is 7% per annum.
Our policyholder could withdraw $7,000 each
year until the total withdrawals reach
$100,000.
This takes 14.28 years.
Note the policyholder can withdraw the funds
irrespective of how the investment account
performs
Here is an example. Market does well at first
and then collapses.
p. 13/4
Example
Year
Rate
Fund before
Fund after
Amount
Balance
on fund
withdrawal
withdrawal
withdrawn
remaining
10%
110,000
103,000
7,000
93,000
10%
113,300
106,300
7,000
86,000
-60%
42,520
35,520
7,000
79,000
-60%
14,208
7, 208
7,000
72,000
- 2.8857%
7,000
Zero
7,000
65,000
6
..
.
r%
..
.
0
..
.
0
..
.
7,000
..
.
58,000
..
.
14
r%
7,000
2000
p. 14/4
The GMWB
The GMWB guarantees a fixed level of
income no matter what happens to the market
Fee for the GMWB is expressed as a
percentage (say fifty basis points) of either
The investment account or
The outstanding guaranteed withdrawal
benefit.
p. 15/4
Assumptions
Perfect frictionless market
Ignore lapses, partial withdrawals mortality etc.
Assume max amount taken each year
Fixed term contract over [0, T ].
Index investment fund dynamics
dIt = It dt + It dBt
where Bt is a Brownian motion under P
is the drift
is the volatility.
p. 16/4
Investors account
Let At be the value of the investors account at time t.
A has an absorbing barrier at zero. Suppose first time it hits zero is .
Dynamics of A for 0 < t < are
dAt = [( q)At g]dt + At dBt
where q is the fee and g is the withdrawal rate.
If the initial investment amount is A0 then
g=
A0
.
T
p. 17/4
p. 18/4
p. 19/4
100
90
80
Account value
70
60
50
40
30
20
10
0
Exercise
0
10
15
Time
p. 20/4
Valuation of GMWB
Use numerical methods to value the contract
(Monte Carlo or pde)
Here we just value a very simple contract
assuming full utilization.
We ignore lapses and mortality and utilization
choice. (Could include them .)
Assume simple lognormal model for
convenience and deterministic interest rates.
p. 21/4
Numerical Example
Benchmark contract, fifteen year term. No lapses no deaths. All policyholders start to
withdraw funds at max rate from the outset. Input parameters are
Parameter
Symbol
Benchmark value
Initial investment
A0
100
Contract term
15 years
Withdrawal rate
6.6667
Volatility
0.20
Riskfree rate
0.05
p. 22/4
Present value of
Put option
basis points
Contributions
3.98
10
0.96
4.07
25
2.36
4.20
48
4.40
4.40
75
6.79
4.67
100
8.87
4.91
200
16.33
5.98
300
22.63
7.17
p. 23/4
20
15
10
0.005
0.01
0.015
0.02
0.025
0.03
p. 24/4
No arbitrage Values
For this example the no arbitrage Value of q is
q = 0.004751
Contributions and Put values when q = 0.004751
Entity
Value (sd)
Value of contributions 4.4012(0.0003)
Value of put option
4.4014(0.0008)
p. 25/4
Present Value of
Put Option
Contributions
0.04
4.29
6.14
0.05
4.40
4.40
0.06
4.50
3.09
p. 26/4
6
5.5
5
4.5
4
3.5
3
2.5
2
4.2
4.4
4.6
4.8
5
5.2
Interest rate
5.4
5.6
5.8
p. 27/4
Sensitivity to volatility
Now vary the volatility
Volatility
Present Value of
Assumption Contributions
0.15
0.20
0.25
4.37
4.40
4.44
Put Option
2.08
4.40
7.07
p. 28/4
Sensitivity to volatility
8
2
15
16
17
18
19
20
Volatility
21
22
23
24
25
p. 29/4
p. 30/4
p. 31/4
200
180
160
140
120
100
80
60
40
20
0
40
60
80
100
120
140
160
180
200
220
240
p. 32/4
p. 33/4
p. 34/4
p. 35/4
2
1.5
1
0.5
0
0.5
1
1.5
2
0.5
1.5
2
2.5
Time in quarters
3.5
p. 36/4
Liability Calculation
Fix I1
Use Brownian bridge to get distribution of
A1 |I1
For each pair (A1 , I1 ) find the GMWB liability
at time one
Find average value of liability given I1
(2)
p. 37/4
Distribution of A1
Fix a value of the index at time one I1 .
Conditional on I1 find the distribution of A1 |I1 .
We have seen that A1 is path dependent.
Next graph assumes I1 = 100 and gives
distribution of A1
p. 38/4
1200
1000
800
600
400
200
0
91
91.5
92
92.5
93
93.5
94
94.5
p. 39/4
Distribution of A1
We can get all the moments of A1 |I1 in
closed form
It turns out that A1 |I1 is almost normal.
We fix I1 and write
A1 = A1 + A z
where A1 = E[A1 ] and where z has mean
zero and variance one.
p. 40/4
V1 as a function of A1
Fix I1 .
We have
V (I1 , A1 ) = V (I1 , A1 + A z)
Using Taylor series and taking expectations
we have
(3)
2)
(
p. 41/4
SS Hedging
Two expressions for EA1 [V (I1 , A1 )] The last one
equation (3) is much more convenient.
Find portfolio of put options to replicate
average liability EA1 [V (I1 , A1 )].
Optimization procedure or apply equation (1).
Repeat after one year
p. 42/4
40
30
20
10
10
20
40
60
80
100
120
140
160
180
Index value after one year
200
220
240
p. 43/4
p. 44/4