Analysis of VIX-linked fee incentives in variable annuities via continuous-time Markov chain approximation

Anne MacKay, Marie Claude Vachon, Zhenyu Cui

Research output: Contribution to journalArticlepeer-review

7 Scopus citations

Abstract

We consider the pricing of variable annuities (VAs) with general fee structures under a class of stochastic volatility models which includes the Heston, Hull-White, Scott, α-Hypergeometric, 3/2, and 4/2 models. In particular, we analyze the impact of different VIX-linked fee structures on the optimal surrender strategy of a VA contract with guaranteed minimum maturity benefit (GMMB). Under the assumption that the VA contract can be surrendered before maturity, the pricing of a VA contract corresponds to an optimal stopping problem with an unbounded, time-dependent, and discontinuous payoff function. We develop efficient algorithms for the pricing of VA contracts using a two-layer continuous-time Markov chain approximation for the fund value process. When the contract is kept until maturity and under a general fee structure, we show that the value of the contract can be approximated by a closed-form matrix expression. We also provide a quick and simple way to determine the value of early surrenders via a recursive algorithm and give an easy procedure to approximate the optimal surrender surface. We show numerically that the optimal surrender strategy is more robust to changes in the volatility of the account value when the fee is linked to the VIX index.

Original languageEnglish
Pages (from-to)1055-1078
Number of pages24
JournalQuantitative Finance
Volume23
Issue number7-8
DOIs
StatePublished - 2023

Keywords

  • American options
  • Continuous-time Markov chain
  • Heston model
  • Optimal stopping
  • Stochastic volatility
  • Variable annuities

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