Abstract

Throughout the past couple of decades, the surge in the sale of equity linked products has led to many discussions on the valuation of surrender options embedded in these products. However, most studies treat such options as American/Bermudian style options. In this thesis, a different approach is presented where only a portion of the policyholders react optimally, due to the belief that not all policyholders are rational. Through this method, a probability of surrender is found and the product is partially hedged by iteratively reducing the measure of risk to a non-positive value. This partial hedging framework is versatile since few assumptions are made. To demonstrate this, the initial capital requirement for an equity linked product is found under a bivariate equity/interest model with a copula based dependence structure. A numerical example is presented in order to demonstrate some of the dynamics of this valuation method. In addition, a surprising result is found during the adjustment of the surrender parameters which directly implies that under a particular valuation method, an increased number of policy surrenders causes a drop in the initial capital requirement. This counter-intuitive result is directly caused by the partial hedging method.