The Fair Value of Pension Liabilities: The Case of Embedded Option in Scenario Analysis
Investment Innovations and Financial Management, Vol. 7, pp. 36-45, 2010
Posted: 9 Jan 2011
Date Written: January 27, 2010
The financial crisis of the beginning of the millennium and the recent crisis have led many pension funds to adopt different management approach to overcome the arising difficulties to maintain a solid financial status. Among these, the adoption of an indexation policy which is now conditional on the solvability of the fund have been widely adopted. Pension funds recognizing conditional inflation indexation targets are obliged to pay an additional payoff that is linked to the inflation rate through some specific rule. The additional payoff normally takes the form of a contingent claim conditional to a “measure” of sustainability of the payoff itself; in most cases, the measure is linked to an asset and liability ratio able to capture and guarantee the solvability of the fund itself. Therefore, a full valuation of the obligation towards fund’s participants and the definition of an optimal investment strategy cannot exclude the proper appraisal of this additional option. The main objective is to provide a value for the inflation indexation as embedded option. Results derive from a simulation procedure applied to an exemplar case by means of scenario-based analysis. Numerical results gives the opportunity to state the absolute value of the “inflation option” and the relative value with respect to the fund’s liability.
Keywords: Conditional Indexation, Barrier Option, Liabilities Valuation, Pension Fund
JEL Classification: C3,G13, G23
Suggested Citation: Suggested Citation