During the last decades, cliquet option based contracts became a very popular and frequently sold investment product in the insurance industry. These contracts can be considered as a customized subclass of equity indexed annuities which combine savings and insurance benefits [3]. The underlying options usually are of monthly sum cap style paying a credited yield based on the sum of monthly-capped rates associated with some reference (stock) index. More precisely, the investor pays a contractually specified amount to the issuer of the option prior to its maturity date and, in turn, receives at maturity a payoff depending on the performance of some designated reference index. In this regard, cliquet type investments belong to the class of path-dependent exotic options. The most popular choice in the insurance branch are cliquet contracts with globally-floored and locally-capped payoffs. These products can be utilized to protect against downside risk while yielding significant upside potential, yet avoiding extreme payoffs due to their local capping (cf. [3, 10, 16]). In [16] cliquet options are regarded as “the height of fashion in the world of equity derivatives”.

In the literature, there are different pricing approaches for cliquet options involving e.g. partial differential equations (see [16]), Monte Carlo techniques (see [1, 2, 5, 9]), numerical recursive algorithms related to inverse Laplace transforms (see [10]) and analytical computation methods (see [1, 3, 5, 8, 9, 11]). In [3] the authors provide semi-analytic pricing formulas for path-dependent equity-linked contracts. They distinguish between cliquet options and monthly sum cap contracts and derive expressions for various Greeks. In their approach, it is crucial to know the probability distribution of the returns of the underlying reference index. In [1] the author uses a Lévy process specification to model the evolution of the underlying reference portfolio and investigates the valuation of life insurance policies providing interest rate guarantees. The driving Lévy process is of jump-diffusion type with normally distributed jump amplitudes while a special focus in [1] is laid on valuation under different risk-neutral pricing measures. In [11] the valuation of insurance contracts is discussed while emphasis is put on the impact of different Lévy process model specifications. It is shown that changing the underlying asset model implies a significant change in the prices of guarantees, indicating a substantial model risk. In [8] the pricing of cliquet options in a geometric Meixner model is investigated. The considered option is of monthly sum cap style while the underlying stock price is driven by a pure-jump Meixner–Lévy process yielding Meixner distributed log-returns. The paper [8] provides a specific application of the results derived in the present article. In [10] cliquet option prices are computed numerically by a recursive algorithm involving inverse Laplace transforms. This method is applied to a lognormal and a jump-diffusion model with deterministic volatility as well as to the Heston stochastic volatility model. In addition, a sensitivity analysis in each model is presented. Moreover, in [7] cliquet option pricing in a jump-diffusion model with time-dependent coefficients is examined. The jumps in the stock price trajectory are interspersed by an increasing standard Poisson process and the time-dependent coefficients are approximated by piecewise constant functions. In [7] there are solely cliquet options with a single resetting time discussed. In [16] the author investigates cliquet option pricing with partial differential equations (PDEs) while putting a special focus on the important role of volatility surface modeling. Recently, there have been extensions beyond Lévy settings to regime switching Lévy models (see e.g. [5, 9]). In [5] the authors investigate the pricing of equity-linked annuities with cliquet-style guarantees in regime-switching stochastic volatility models with jumps. They propose a transform-based pricing method involving density projections and continuous-time Markov chain approximations. The considered models include exponential and regime-switching Lévy processes as well as stochastic volatility models with general jump size distributions. In [9] the valuation of equity-linked life insurance contracts in a regime switching Lévy model is studied. The model parameters depend on a continuous-time finite-state Markov chain, and closed-form pricing formulas based on Fourier transform techniques are derived.

The aim of the present paper is to provide analytical pricing formulas for globally-floored locally-capped cliquet options with multiple resetting times where the underlying reference stock index is driven by a drifted time-homogeneous Lévy process with Brownian diffusion component and compound Poisson jumps. In our framework, jumps represent rare events such as crashes, large drawdowns or upward movements. The dates of e.g. market crashes are modeled as arrival times of a standard Poisson process while the jump amplitudes can be both positive and negative. With reference to Section 4.1.1 in [4], we state that jump-diffusion models are easy to simulate and efficient Monte Carlo methods for option pricing are available. Jump-diffusion models also perform well when it comes to implied volatility smile interpolation (see Section 13 in [4]). In our setup, we derive cliquet option price formulas under two different approaches: once by using the distribution function of the driving Lévy process and once by applying Fourier transform techniques. In the context of sensitivity analysis, we eventually provide expressions for several Greeks related to our model.

The paper is organized as follows: In Section 2 we introduce the jump-diffusion stock price model and derive representations for the probability density and distribution function of the driving Lévy process. In Section 3 we are concerned with cliquet option pricing under both a distribution function and a Fourier transform approach. Section 4 is dedicated to sensitivity analysis and the computation of different Greeks. In Section 5 we draw the conclusions and briefly mention some future research topics.

Let (Ω,F,(Ft)t∈[0,T],Q) be a filtered probability space satisfying the usual hypotheses, i.e. Ft=Ft+:=∩s>tFs t}}{\mathcal{F}_{s}}$]]> constitutes a right-continuous filtration and F denotes the sigma-algebra augmented by all Q -null sets (cf. p. 3 in [13]). Here, Q is a risk-neutral probability measure and 0<T<∞ denotes a finite time horizon. In the sequel, we introduce a stochastic model for the stock price process St . Let t∈[0,T] and consider the stochastic differential equation (SDE) dSt=η(t,St)dt+σ(t,St)dWt+∫Rθ(t,z,St−)dN(t,z) where η, σ and θ are deterministic functions, W constitutes an F -adapted standard Brownian motion under Q and N is a Poisson random measure (PRM). We further introduce the Q -compensated PRM (2.1) dN˜(s,z):=dN(s,z)−dν(z)ds which constitutes an (F,Q) -martingale integrator on [0,T]×R with positive and finite Lévy measure ν satisfying ν({0})=0 and ∫R(1∧z2)dν(z)<∞ (cf. Eq. (3.14) in [4]). In the above setup, we refer to η, σ and θ as the drift, volatility and jump function, respectively. We assume that W and N are Q -independent and set Ft:=σ{Su:0≤u≤t} for all t∈[0,T] . In the next step, we specify the emerging coefficients as follows η(t,St):=η(t)St,σ(t,St):=σ(t)St,θ(t,z,St−):=θ(t,z)St− while assuming that θ(t,z)>−1 -1$]]> for all (t,z)∈[0,T]×R and that EQ[∫0T(|η(t)|+σ2(t)+∫Rθ2(t,z)dν(z))dt]<∞ (cf. Section 9.1 in [6]). Consequently, we obtain the geometric SDE dStSt−=η(t)dt+σ(t)dWt+∫Rθ(t,z)dN(t,z) which possesses the discontinuous Doléans-Dade solution St=S0exp{∫0t(η(s)−12σ2(s))ds+∫0tσ(s)dWs+∫0t∫Rln(1+θ(s,z))dN(s,z)} for all t∈[0,T] . From now on, we set η(t)≡η , σ(t)≡σ>0 0$]]> and θ(t,z):=ez−1 in order to obtain a time-homogeneous Lévy process specification. If we do so, the latter equation can be written as (2.2) St=S0eXt with a real-valued Lévy process (2.3) Xt:=γt+σWt+∫0t∫RzdN(s,z) where γ:=η−σ2/2 and t∈[0,T] . Note that X0=0 Q -a.s. We denote the characteristic triplet of X by (γ,σ,ν) . Moreover, the first moment of X is given by EQ[Xt]=t(γ+∫Rzdν(z)) whereas the characteristic function of X can be computed by the Lévy–Khinchin formula (see e.g. [4, 6, 14, 15]) due to (2.4) ϕXt(u):=EQ[eiuXt]=eψ(u)t with i2=−1 , u∈R , t∈[0,T] and characteristic exponent (2.5) ψ(u):=iuγ−12σ2u2+∫R[eiuz−1]dν(z). More details on Lévy processes can be found in e.g. [4, 6, 14, 15]. In the next step, we define the discounted stock price Sˆt:=StBt where St is such as defined in (2.2) and Bt:=ert is the value of a bank account with normalized initial capital B0=1 and risk-less interest rate r>0 0$]]>. Due to (2.2), we find Sˆt=S0eXt−rt while Itô’s formula yields the following geometric SDE under Q dSˆtSˆt−=(η−r+∫R[ez−1]dν(z))dt+σdWt+∫R[ez−1]dN˜(t,z). In accordance to no-arbitrage theory, the discounted stock price process Sˆt must form a martingale under the risk-neutral probability measure Q . For this reason, we have to require the drift restriction η=r−∫R[ez−1]dν(z). With this particular choice of the drift coefficient η, we obtain dStSt−=rdt+σdWt+∫R[ez−1]dN˜(t,z) under Q . Summing up, if we model the stock price process St as in the latter equation, then the discounted stock price Sˆt constitutes a Q -martingale.

Furthermore, let us define the Fourier transform, respectively inverse Fourier transform, of a function q∈L1(R) via qˆ(y):=∫Rq(x)eiyxdx,q(x)=12π∫Rqˆ(y)e−iyxdy.

In what follows, we investigate in detail the jump part of the Lévy process X denoted by Lt:=∫0t∫RzdN(s,z)= ∑j=1NtYj which constitutes a càdlàg, finite activity compound Poisson process (CPP) with finitely many jumps in each time interval. In the latter equation, Nt constitutes a standard Poisson process under Q with deterministic jump intensity λ>0 0$]]>, i.e. Nt∼Poi(λt) , while Y1,Y2,… are i.i.d. random variables modeling the jump amplitudes. We put β:=EQ[Y1] . Recall that the compensated compound Poisson process (Lt−βλt)t constitutes an (Ft,Q) -martingale which implies βλ=∫Rzdν(z) thanks to (2.1). Note that Nt shall not be mixed up with the Poisson random measure dN(s,z) . Obviously, we may write Xt=γt+σWt+Lt . We assume that the stochastic processes Wt , Nt and the random variables Y1,Y2,… altogether are Q -independent.

Recall that the stochastic process St will serve as our stock price model when it comes to cliquet option pricing in the subsequent section. In this context, for n∈N we introduce the time partition P:={0<t0<t1<⋯<tn≤T} and define the return/revenue process associated with the period [tk−1,tk] via (2.10) Rk:=Stk−Stk−1Stk−1=eXtk−Xtk−1−1 where k∈{1,…,n} and X is the Lévy process defined in (2.3). Note that R1,…,Rn are Q -independent and that Rk>−1 -1$]]> Q -almost sure for all k. For the sake of notational simplicity, we always work under the assumption of equidistant time points in the following and define τ:=tk−tk−1 . If we want to refrain from this assumption again, then τ simply has to be replaced by the difference tk−tk−1 in all subsequent equations – with (3.17) as an exception.

In quantitative risk management, it is often of interest to compute the probability of large drawdowns (shocks) in asset prices like e.g. Q(Su≤κSt) , 0≤t<u≤T , where κ constitutes some stress scenario percentile like 60%, for instance. Due to (2.2), we find Q(Su≤κSt)=Q(Xu−t≤lnκ) which can easily be computed by Corollary 2.8.

This section is dedicated to the pricing of cliquet options in the Lévy jump-diffusion stock price model presented in Section 2. In accordance to (1.1) in [3], we consider a cliquet option with payoff HT=K+Kmax{g, ∑k=1nmin{c,Rk}} where T is the maturity time, K denotes the notional (the initial investment), g is the guaranteed rate at maturity, c≥0 is the local cap and Rk is the return process defined in (2.10). This option is of monthly sum cap style with credited rate based on the sum of the monthly-capped rates [3]. Verify that the payoff HT is globally-floored and locally-capped. A popular choice in the insurance industry is to take g=0 (globally-floored by zero) and n=12 (monthly-capped by c). Further, note that the payoff HT actually is a function of multiple random variables, i.e. HT=h(R1,…,Rn)=h‾(St0,…,Stn) wherein h and h‾ are appropriately defined functions while the resetting times of the cliquet option are ordered as follows 0<t0<t1<⋯<tn≤T . In this regard, a notation like Ht0,…,tn(T) might be more intuitive than simply writing HT . However, by a case distinction we observe HT=Kmax{1+g,1+ ∑k=1nmin{c,Rk}}=K(1+g+max{0, ∑k=1nZk}) where Zk:=min{c,Rk}−g/n denote i.i.d. random variables. Moreover, we introduce a bank account dBt=rBtdt with constant interest rate r>0 0$]]> and initial capital B0=1 , i.e. Bt=ert . Then the price at time t≤T of a cliquet option with payoff HT at maturity T is the discounted risk-neutral conditional expectation of the payoff, i.e. Ct=e−r(T−t)EQ(HT|Ft). Combining the latter equations, we obtain (3.1) C0=Ke−rT(1+g+EQ[max{0, ∑k=1nZk}]) which shows that the considered cliquet option with payoff HT essentially is a plain-vanilla call option with strike zero written on the basket-style underlying ∑k=1nZk .

More explicit expressions for ϕZ(x) and EQ[Z1] are derived in several propositions below.

The remaining challenge now consists in finding appropriate computation techniques for the entities EQ[Z1] and ϕZ(x) emerging in (3.2). In the subsequent sections, we present different methods to derive expressions for the mentioned entities. Similar to the notation introduced in Proposition 2.9, for arbitrary k∈{1,…,n} we set τ=tk−tk−1 in the following. We also assume that the jump amplitudes are normally distributed, as pointed out in Example 2.2.