Valuation of the Conditional Indexation Option in Asset and Liability Management of Defined Benefit Pension Funds

MATHEMATICAL AND STATISTICAL METHODS FOR INSURANCE AND FINANCE, C. Perna, M. Sibillo, eds., Springer Verlag, Forthcoming

Posted: 18 Jan 2011

See all articles by Rosa Cocozza

Rosa Cocozza

University of Naples Federico II - Faculty of Economics

Angela Gallo

Cass Business School

Giuseppe Xella

University of Naples Federico II

Date Written: January 15, 2011

Abstract

Pension funds have adopted different management approaches to overcome the arising difficulties to maintain a solid financial status. Among these, there is the adoption of an indexation policy which is conditional on the solvability of the fund. Pension funds recognizing conditional inflation indexation are obliged to pay an additional payoff 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/liability ratio able to capture the solvability of the fund. Therefore, a full valuation of the obligation towards funds participants cannot exclude the proper appraisal of this additional option. The option payoff is conditional to a measurement asset that is different from the reference underlying asset. This structure recalls a barrier option with different measurement and payoff asset. The paper investigates the opportunity to apply barrier option schemes in an asset/liability context to provide a full valuation of the obligation towards participants. Results derive from a simulation procedure applied by means of scenario-based analysis. Numerical results give the opportunity to state the absolute and relative value of the inflation option.

Keywords: Conditional indexation, ALM, barrier option, pension funds

JEL Classification: G11, G23

Suggested Citation

Cocozza, Rosa and Gallo, Angela and Xella, Giuseppe, Valuation of the Conditional Indexation Option in Asset and Liability Management of Defined Benefit Pension Funds (January 15, 2011). MATHEMATICAL AND STATISTICAL METHODS FOR INSURANCE AND FINANCE, C. Perna, M. Sibillo, eds., Springer Verlag, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1742180

Rosa Cocozza (Contact Author)

University of Naples Federico II - Faculty of Economics ( email )

Via Cintia Monte S. Angelo
Napoli, 80126
Italy
+39/81675083 (Phone)

HOME PAGE: http://www.docenti.unina.it/rosa.cocozza

Angela Gallo

Cass Business School ( email )

London
Great Britain

Giuseppe Xella

University of Naples Federico II ( email )

via Cinthia
Dipartimento di Matematica e Statistica
Naples, Naples 80126
Italy

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