Finance Research Group Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: This paper introduces, prices, and analyzes traffic light options. The traffic light

option is an innovative structured OTC derivative developed independently by several

London-based investment banks to suit the needs of Danish life and pension (L&P)

companies, which must comply with the traffic light solvency stress test system introduced by the Danish Financial Supervisory Authority (DFSA) in June 2001. This monitoring system requires L&P companies to submit regular reports documenting the sensitivity of the companies’ base capital to certain pre-defined market shocks – the red and yellow light scenarios. These stress scenarios entail drops in interest rates as well as in stock prices, and traffic light options are thus designed to pay off and preserve sufficient capital when interest rates and stock prices fall simultaneously. Sweden’s FSA implemented a traffic light system in January 2006, and supervisory authorities in many other European countries have implemented similar regulation. Traffic light options are therefore likely to attract the attention of a wider audience of pension fund managers in the future. Focusing on the valuation of the traffic light option we set up a Black-Scholes/Hull-White model to describe stock market and interest rate dynamics, and analyze the traffic light option

in this framework.

Keywords: Traffic light solvency tests; regulatory solvency requirements; asset-liability management in pension funds; hedging interest rate and stock price risk; derivatives pricing; Black-Scholes/Hull-White model

34 pages, November 13, 2006

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