Valuation of Cliquet Options

Submitted by:
Michael Shparber
Sharon Resheff

August 2004
 TABLE OF CONTENTS

1 Introduction................................................................................................................. 3
2 The Cliquet Option ..................................................................................................... 4
2.1 Closed-form solutions......................................................................................... 5
2.2 Binomial Solutions ............................................................................................. 7
2.3 Other Solutions ................................................................................................... 7
3 Valuation Techniques ................................................................................................. 9
3.1 Adjusted Risk-Neutral Probabilities Binomial Valuation................................... 9
3.1.1 The HH Approach....................................................................................... 9
3.1.2 Extension................................................................................................... 10
3.2 Backward Valuation CRR Binomial Approach................................................ 13
3.2.1 Introduction............................................................................................... 13
3.2.2 Cliquet Options Behavior and Analysis.................................................... 15
3.3 Monte Carlo Simulation.................................................................................... 27
4 Excel ......................................................................................................................... 30
4.1 Adjusted Risk-Neutral Probabilities Binomial Valuation................................. 30
4.2 Backward Valuation Binomial Approach......................................................... 34
4.3 Monte Carlo Simulation for European Cliquet Options Valuation .................. 38
4.4 Pricing Model Comparison ............................................................................... 40
4.5 Sensitivity Analyses Using Our Backward Valuation Approach ..................... 41
5 Conclusion ................................................................................................................ 44
6 Bibliography ............................................................................................................. 45

2
1 Introduction

Recent turmoil in financial equity markets has caused an increase in demand for products
that reduce downside risk while still offering upside potential. Reset options, also termed
cliquet, ratchet, and strike reset options, provide a product structured to meet that
demand. Reset puts, appeal to large pension funds, portfolio insurers as well as retail
investors.

In this paper we first review existing cliquet option valuation models. We then develop
three new alternate models and using VBA implement them to price cliquet options.

Our paper is organized as follows:

Chapter 2 starts by describing the cliquet option mechanism. We then review of one of
the first models developed to price cliquet put options, and several other models found in
the literature. In Chapter 3 we develop our own alternate valuation models and
extensions to existing models. In this chapter we will also conduct an in-depth sensitivity
analysis of cliquet option behavior, using one of the valuation techniques we proposed.
In Chapter 4 we explain in detail the Excel files and VBA functions used to implement
our valuation techniques. Chapter 5 summarizes and concludes our paper.

3
2 The Cliquet Option

The first cliquet options to be traded on a public exchange were S&P 500 bear market
warrant with a periodic reset. These started trading on the Chicago Board of Options
Exchange in 1996. These reset warrants on the S&P 500 index work like regular equity
or index puts except that the exercise price is reset at a higher level if the index level is
above the original exercise price on the reset date. The term sheet in Figure 1 illustrates
the mechanics of the reset put option.

Five-year Reset Put on ABC Index

Option Buyer XXX
Option Seller YYY
Start Date dd/mm/yyyy
Maturity Date Start date + 5 years
Option Seller Pays at Maturity:
St – ST if St > X, ST ≤ St
X – ST if St ≤ X, ST ≤ X
0 if (St > X and ST > St) or (St ≤ X and ST > X)

where X is the original exercise price (which is the closing stock or index price on the
date of issuance), St is the closing stock or index price on the reset date, and ST is the
closing stock/index price on the expiration date.

Figure 1: Term Sheet of a European-style reset put option with a single reset date

A European style reset put option entitles its holder upon exercise to the difference
between the exercise price and the underlying stock price – just like a regular European
put option. However, the exercise price of a reset put is subject to change. On the
issuance date, the exercise price is set to the current stock price, S0. Upon the reset date
(specified in advance) if the stock price (St) is higher than the original exercise price (S0)

4
the exercise price is ‘reset’ to be equal to the prevailing stock price St. The value of a
reset put with a single reset date is summarized in Figure 1.

The time subscripts t and T represent the reset date and the expiration date of the put,
respectively. The first case is where the reset put is in-the-money at expiration (ST ≤ St),
after having its original exercise price reset at the stock price at time t because the stock
price exceeded the original exercise price (St > X). In the second case, the stock price on
the reset date St was less than the original exercise price X, therefore there was no reset.
Since the exercise price is greater than the stock price on the expiration date, ST ≤ X, the
option holder receives the difference X – ST. In the third case, the put is out-of-the-
money at expiration, independent of whether or not the put’s exercise price was reset.

2.1 Closed-form solutions

Gray & Whaley (1999) (GW) proposed a closed-form solution for the European reset
(cliquet) put option described above. Their approach was to divide the expected terminal
payoffs of the cliquet to three possible outcomes, as shown in Figure 1, and to derive the
overall expected value through the probabilities of each outcome.

The price of their cliquet put option Putt(S, X) is given by:

where:

5
and N2(a, b; ρ) is a cumulative bivariate normal distribution function with upper integral
limits a and b and the correlation coefficient ρ.
Although GW derived a closed-form solution for European reset puts, their approach can
be implemented to derive European reset call pricing formula as well, as do Haug &
Haug (2001) (HH).

Another closed-form solution can be found for a different type of cliquet (ratchet) option.
This cliquet is a series of at-the-money options, with periodic settlement, resetting the
strike value at the then current price level, at which time, the option locks in the
difference between the old and new strike and pays that out as the profit. The profit can
be accumulated until final maturity, or paid out at each reset date.

The difference between these cliquets and those analyzed by GW (1999) is that the strike
of the former resets regardless of whether the stock price is above or below the original
strike at the reset date. This allows us to price these cliquets as a series of forward-start
options using the Rubinstein (1991) approach. Rubinstein showed that the value of a
forward-start option is simply the current value of d-t vanillas which are currently at-the-
money, with time to expiration T–t (where d is the continuous dividend payout rate).

The price of such a cliquet is given by:

where:

and .
The formula is taken from the www.global-derivatives.com.

Again, this closed-form solution is not suitable for the GW type cliquet options that reset
the strike price only if at the reset date it is below/above (for put/call respectively) the
underlying stock price.

6
This leads us to the main weakness of closed-form solutions of this kind: the lack of
flexibility. Any slight change in option conditions or payoffs requires a new solution and
maybe a completely different approach. With a large variety of different exotics that are
currently traded, and an even larger number of exotics that are expected to be "invented",
the task of finding closed-form pricing solutions may turn out to be futile (as many
options do not have a closed-form solution), or at best extremely time consuming.

Another problem with closed-form solutions (or ours rather) is the complex math
involved.

Having these disadvantages in mind, HH (2001) proposed a binomial method for pricing
European reset options.

2.2 Binomial Solutions

HH develop an analytical equation for valuing European reset options using a binomial
tree. The authors calculate the probabilities of ending at each node and then discount at
the risk free interest rate. The advantage of this approach is that it offers a flexibility that
the GW method lacks. Many types of reset option can be valued, with different types of
payoffs at maturity. The HH method yields similar results to those of GW.

In Chapter 3.1 we discuss the HH method in detail and propose an extension to their
model.

2.3 Other Solutions

We found a number of academic as well as practical articles that value reset options using
various methods. Wilmott (2001) states that exotic options, such as cliquets, have a
greater sensitivity to volatility than do plain vanilla contracts. Using the vega measure to
hedge cliquets is incorrect. Vega is defined as the derivative of the option value with

7
respect to its volatility, which is usually taken to be constant. Most exotic options have a
gamma which changes sign. This causes vega to be small at precisely those places where
sensitivity to actual volatility is very large. Wilmott uses valuation models that take into
account a changing volatility to show that the sensitivity to volatility is much larger than
a regular vega calculation would suggest. Wilmott uses Monte Carlo simulation as well
as partial differential equations to value the reset option.

The greatest advantage of Monte-Carlo simulation pricing is that this model can be most
easily adjusted for almost any other type of cliquet options (for instance: multiple-reset
compound ratchets, coupe options, barrier cliquets, etc.) as well as for many other
different path-dependent exotics.

In Chapter 3.3 we develop a Monte Carlo simulation for pricing cliquet options.

Windcliff et al. (2003) use Merton’s jump diffusion model to value cliquet options. We
honestly tried, but sadly, could not understand a word they wrote.

Other solutions can be found in the literature: Schoutens and Symens (2002), Buetow
(1999).

8
3 Valuation Techniques

In this chapter we review some of the existing cliquet option valuation models. We also
develop three new alternate models and implement them using VBA.

From this point on, we will stick to the valuation of cliquet options, introduced by GW,
and described in Chapter 2.

3.1 Adjusted Risk-Neutral Probabilities Binomial Valuation

3.1.1 The HH Approach

The first cliquet model we present is based on the binomial tree of Cox, Ross and
Rubinstein (1979) (CRR). HH (2001) showed how the Reset options may be priced
using this tree in the setting of Rendleman and Bartter (1979), when the probabilities of
going up or down are set equal to 0.5. The corresponding sizes of the moves up or down
at each time step, ∆t apart, are
σ2
(b − ) ∆t +σ ∆t
u=e 2 ,
σ2
(b − ) ∆t −σ ∆t
d =e 2 .

and b is the cost of carry term. (Under our assumption of continuously paid dividend b =
r-div).
Haug&Haug show that under this assumption the value of an European reset call is:
m n−m+ j n
m! (n − m)! 1
C = e − rT ∑∑
j =0 i= j
×   g ( Su i d ( n −i ) , X c )
j! (m − j )! (i − j )! (n − m − i + j )!  2 
(1)

where
g ( S , X ) =max(S-X,0),

X c = min( Su j d ( m − j ) , X )

A put reset option is valued by the same expression (1) but with

9
g ( S , X ) =max(X-S,0),

X p = max(Su j d ( m − j ) , X ) .

3.1.2 Extension

We extend the Haug&Haug model by removing the assumption of equal probabilities of

0.5. We calculate the risk-neutral "adjusted" probabilities (under the CRR approach).

In our model we assume the up and down movements to be

1
U = eσ ∆t
and D = e −σ ∆t
(or D = ).
U

where ∆t=T/n is the size of each time step, and n is the number of time steps.
The probability of an up step (the stock price increasing at the next time step) is
e b∆t − D
p= and the probability of a down step is (1-p). b=r-div is the cost of carry term,
U −D

mentioned above.

The up-down movements and probabilities are "adjusted" so that this discrete binomial
model approximates the continuous Brownian motion of stock prices.

Next, we use these assumptions about the underlying stock behavior and the HH model to
price European cliquet options.

As in the Haug & Haug model, we let n denote the number of time steps to maturity, m
the number of time steps to the reset time, i the number of up steps at maturity and j the
number of up steps at the rest date. The probability that St passes through step j at the
reset date m and ends at state i at maturity n is P{(i, n) ∩ ( j, m)} = P{(i, n) | ( j, m)}P{( j, m)} .
The probability of going through state j starting from the beginning is
m!
P{( j , m)} = p j (1 − p ) m − j
j! (m − j )!

The probability of ending in state i when starting at (j,m) is

10
 (n − m)!
P{(i, n) | ( j , m)} = p i − j (1 − p) n − m −i + j
(i − j )! (n − m − i + j )!

As opposed to the Haug & Haug model, we do not assume equal probabilities of 0.5, but
calculate risk-neutral probabilities using the CRR approach as explained above.

Thus, we have that the probability of stock price going though (j,m) and ending at (i,n) is
m! (n − m)!
P{(i, n) ∩ ( j , m)} = P{(i, n) | ( j , m)}P{( j , m)} = p i (1 − p ) n −i .
j! (m − j )! (i − j )! (n − m − i + j )!

The value of a cliquet option is the sum of the payoffs multiplied by the corresponding
probabilities. We may discount those payoffs at the risk-free rate since our calculated
probabilities are adjusted risk-neutral probabilities.

The value of a European cliquet Call option is therefore

m n−m+ j
m! (n − m)!
CliquetCall adj = e − rT ∑∑
j =0 i= j
j! (m − j )! (i − j )! (n − m − i + j )!
p i (1 − p) n −i Max( Su i d n −i − X , Su i d n −i − Su j d m − j ,0)

Note that Su i d n −i − Su j d m − j is a maximum (for an in-the-money option at maturity) when

the strike was reset to the then-current stock price ( X new = Su j d m − j ). This follows from the
cliquet options' property, according to which the strike price will reset only when it is
advantageous to do so, i.e., when resetting brings out-of-the-money options in to the
money. Therefore, this property can only benefit cliquet holders.

The value of a European cliquet put is given by:

m n−m+ j
m!(n − m)!
CliquetPutadj = e − rT ∑∑
j =0 i= j
j!(m − j )!(i − j )!(n − m − i + j )!
p i (1 − p) n − i Max( X − Su i d n − i , Su j d m − j − Su i d n − i ,0)

(In our VBA implementation we use one function to price both calls and puts using the
Boolean variable z. See Chapter 4.1 for more details)

11
The HH approach and our extension of it have a flexibility that the GW closed-form
solution formula lacks. They can be relatively easy to adjust to price such cliquets as
power reset options (with payoff Max(S2-X2,0)), barrier reset options or time reset
options (for implementations see HH 2001). Such extra-toppings as floors and caps can
be easily added to this methods also.

Table 1 compares GW, HH and our adjusted model. The parameters used are S=100,
X=100, T=1, r=10%, div=0%, σ=30%, n=150. Tau is years to reset.

For a complete explanation of the Excel and VBA implementation, see chapter 4.1.

tau=0.25 tau=0.50 tau=0.75

Volatility B&S G&W H&H Adjusted G&W H&H Adjusted G&W H&H Adjusted
Call
0.1 10.308 10.934 10.929 10.938 10.833 10.838 10.833 10.656 10.663 10.646
0.2 13.270 14.583 14.593 14.600 14.566 14.585 14.577 14.273 14.294 14.257
0.3 16.734 18.585 18.626 18.630 18.663 18.664 18.691 18.308 18.329 18.286
Put
0.1 0.792 1.169 1.165 1.166 1.373 1.379 1.374 1.497 1.506 1.478
0.2 3.753 4.938 4.954 4.953 5.329 5.351 5.344 5.379 5.406 5.353
0.3 7.218 9.239 9.288 9.291 9.792 9.803 9.837 9.754 9.785 9.725

Table 1: Model comparison

As the table shows, our values are very close to those of GW and HH.

Although the binomial pricing approach has many advantages that were discussed above,
it also has several disadvantages.

One of the drawbacks of this model is that it doesn't allow for the valuation of American
cliquet options. In Chapter 3.2.1 of this paper we develop another binomial model using
a backward valuation approach to price both European and American cliquets.

Another weakness of any binomial discrete model is that you have to use a lot of time
steps to have a good approximation to a continuous pricing model. The more steps the
better, but the tradeoff is longer time needed for calculations.

12
There is also a "bug" in computer implementation of this approach. Due to Excel or other
computer restrictions we cannot use more than 196 time steps for this model calculations,
probably because of the very large numbers returned by fact() function.
Our backward valuation approach introduced in the next section overcomes this problem
because no factorials are involved.

3.2 Backward Valuation CRR Binomial Approach

3.2.1 Introduction

In this section we develop a binomial cliquet option valuation model which maintains the
important property of flexibility, as does the HH approach, but also allows us to price
American cliquets.

The settings for this model are the same as those described in the previous section:
We have the Cox-Ross-Rubinstein (CRR) binomial tree with
U = eσ ∆t
and D = e −σ ∆t

e b ∆t − D
The adjusted risk-neutral probability for the up state is p = and (1-p) for the down
U −D

state. This time, instead of calculating the probability of each payoff, we use the
backward vanilla valuation approach described in many textbooks (e.g. Benninga (2001),
Hull (2003), Haug (1997)), adjusting it to cliquet options.

The adjustment is as follows:

For each node that falls under the reset date m, the new strike price is determined. If the
stock price at m is above the original strike, the put will reset its strike price equal to the
then-current stock price. For call options: if the stock price m is below the original strike,
the call will reset its strike price equal to the then-current stock price. Now we have

13
m+1 different nodes, each of which is a plain vanilla that starts at m, matures at n, thus
having n-m steps to maturity, with a determined strike and the underlying stock price Sm.
We valuate these vanillas using standard backward valuation by discounting the expected
option value in the following step (and checking an early exercise possibility for
American cliquets). Here, as in our HH extension model, we can discount at a risk-free
rate since we use risk-neutral probabilities for up/down states.

Having priced (m+1) nodes, the problem is reduced to pricing a vanilla option which is
issued today, expires at the reset date m, and has the original strike. Its final "payoffs",
though, are not regular "Max(S-X,0)" but rather the values of those m+1 vanillas, we just
calculated. We price this option using the same backward technique (remembering to
check for early exercise possibilities for Americans), until we find its current value.

The advantages of this backward valuation binomial model include all those of the
factorial HH approach, but, as opposed to HH:
This model does price American cliquets.
There are no factorials here. More time steps can be used, improving accuracy. Note that
despite the fact that cliquet options are path-dependent, we don't have to valuate 2n end
nodes, thus, tremendously speeding the calculations.
This backward valuation approach is even more flexible than the HH method. For
instance, with slight adjustment it allows us to price a cliquet with multiple reset periods.
The "probabilities" model of HH lacks this ability.

This model allows us to investigate cliquet options' behavior, their sensitivity to changes
of different parameters, deltas, etc., including American cliquets. We conduct such
analysis in chapter 3.2.2.

Note that this method yields the same results as does our extended HH model with risk-
neutral probabilities, for European cliquets. This is due to the same settings and
assumptions for these two binomial models.

14
For a complete explanation of the Excel and VBA implementation, see chapter 4.2.

3.2.2 Cliquet Options Behavior and Analysis

In this section we conduct and report the results of several sensitivity analyses of cliquet
option behavior. Our backward valuation pricing method allows us to single out the
affects of individual parameters on the cliquet option value, as well as test these affects
for different types of cliquets, including American. Other methods do price American
options, much less permit sensitivity analysis for them.

For the purposes of conducting the analyses, we used the Excel file
“Backward_CRR_Cliquet_Analysis” that we developed. For an explanation, please refer
to Chapter 4.5.

We used the following parameters for our analysis:

Initial stock price = 100
Exercise price = 100
Time to maturity = 1 year
Time to reset = 0.5 year
Risk-free interest rate = 10%
Dividend yield = 5%
Sigma = 30%.
To calculate the option value we entered 100 steps (or movements) until the date of
maturity (50 steps to the reset date).

Table 2 summarizes the option values results using the Cox-Ross-Rubinstein model to
value European and American style plain vanilla calls and puts, versus cliquet options,
priced with our backward valuation technique.

15
 Plain vanilla Cliquet

European Call 13.509 15.442

European Put 8.870 11.453
American Call 13.511 15.444
American Put 9.571 12.275

Table 2: Comparison of Cliquet and plain vanilla option values

As Table 2 shows, the price of cliquet options is greater than that of plain vanilla options.
This should not be surprising because the probability to be in-the-money is greater for a
cliquet option.

3.2.2.1 Sensitivity to Stock Price Changes

In some cases the prices of cliquets and plain vanilla options converge. For instance, as
stock prices fall, the price of a cliquet put option approaches and might even equal the
price of a plain vanilla put. This is because that for falling stock prices the possibility or
attractiveness of resetting the option exercise price diminishes. For a call option this
holds in the opposite direction: as stock prices rise, the value of a cliquet option
approaches that of a plain vanilla option. Figure 2 and Figure 3 show the sensitivity of
option values to changes in the underlying stock prices.

16
 European Call - Sensitivity to Current Stock Price
100.00

90.00

80.00

Option Value 70.00

60.00

50.00

40.00

30.00

20.00

10.00

0.00
0.00 50.00 100.00 150.00 200.00 250.00
Current Stock Price

Vanilla Cliquet

Figure 2: Sensitivity of European call option prices to changes in underlying stock price

European Put - Sensitivity to Current Stock Price

100.00

90.00

80.00

70.00
Option Value

60.00

50.00

40.00

30.00

20.00

10.00

0.00
0.00 50.00 100.00 150.00 200.00 250.00
Current Stock Price

Vanilla Cliquet

Figure 3: Sensitivity of European put option prices to changes in underlying stock price

As stock prices rise, cliquet and vanilla call option prices converge. As stock prices fall,
cliquet and vanilla put option prices converge.

17
 3.2.2.2 Sensitivity to Volatility Changes

Figure 4 and Figure 5 illustrate the affect volatility has on cliquet and vanilla option
prices.

European Call - Sensitivity to Stock Volatility

45.00
40.00
35.00
Option Value

30.00
25.00
20.00
15.00
10.00
5.00
0.00
0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%
Stock Volatility

Vanilla Cliquet

Figure 4: Sensitivity of European call option prices to changes in stock volatility

18
 European Put - Sensitivity to Stock Volatility

50.00
45.00
40.00

Option Value
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%
Stock Volatility

Vanilla Cliquet

Figure 5: Sensitivity of European put option prices to changes in stock volatility

Call and put option prices demonstrate similar trends with respect to changes in volatility.
Options theory teaches that as volatility increases, option values increase. For cliquet
options, as volatility increases, the chance of resetting increases. If the probability of
reset is higher, the probability of the option being in-the-money increases, and therefore
the value of the cliquet option increases over that of the plain vanilla option.

3.2.2.3 Sensitivity to the Changes in the Reset Date

Figure 6 displays the sensitivity of cliquet call option values to the reset date.

19
 Cliquet Call - Sensitivity to reset date
16.00

15.50

15.00
Option Value

14.50

14.00

13.50

13.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20
Time to reset

European American

Figure 6: Cliquet call option sensitivity to time left to reset date

As the length of time between the issuance date and the reset date increases, the higher
the value of the cliquet option. This is only partially true. Starting at some point in time,
as the reset date approaches the maturity date, the value of the cliquet decreases. This is
because the stock price has limited opportunity to increase in value above the reset
exercise price. Therefore, the maximum value attainable is achieved somewhere in
between, in this case after about 6 months pass from the issuance date.

Another interesting fact we can observe from Figure 6 is that American and European
call cliquet option prices are equal. This happens when the underlying asset pays no, or
little, dividends, as shown later on in this section.

20
 Cliquet Put - Sensitivity to Time to reset
14.00

12.00

Option Value 10.00

8.00

6.00

4.00

2.00

0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20
Time to reset

European American

Figure 7: Sensitivity of a cliquet put option to the reset date

The cliquet put option exemplifies a similar trend of sensitivity to the reset date, as Figure
7 shows. The maximum option value is 11.552 and 12.352 for the European and
American style put options respectively. This is reached at t = 0.55. The value of the
American cliquet put option is greater than that of the European cliquet. This is due to
the early exercise opportunity gained by the American put option holder.

21
 3.2.2.4 Sensitivity to Dividend Payout Rate Changes

Cliquet Call - Sensitivity to Dividend Rate

20.00

18.00

16.00

14.00
Option Value

12.00

10.00

8.00

6.00

4.00

2.00

0.00
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Dividend Rate

European American

Figure 8: Cliquet call option values and the dividend rate

Figure 8 plots the value of American and European cliquet options as a function of the
dividend rate. As mentioned previously, it is not optimal to exercise an American call
option early for a non-dividend, or small dividend, paying stock. Therefore, as can be
seen in Figure 8, American and European call options have equal prices when dealing
with such stock. This observation is consistent with a similar well-known fact
concerning plain vanilla options. Cliquet options started trading on indexes like the S&P
500, therefore we cannot use the price equality rule for American and European cliquets.

In our case, for dividend payout rates below 4%, the price equality rule for standard
American and European call options holds for cliquets as well. Beyond the 4% dividend
rate, the value of the American cliquet exceeds its European counterpart. The early
exercise feature of American calls becomes a relevant opportunity past the 4% dividend
rate and explains the gap in values observed.

22
American and European put options do not exemplify the same price equality as call
options. American and European cliquet put options are graphed in Figure 9. American
and European cliquet put option prices approach equality as the dividend yield grows,
however the American option value exceeds that of the European by a small margin.

Cliquet Put - Sensitivity to Dividend Rate

20.00

18.00

16.00

14.00
Option Value

12.00

10.00

8.00

6.00

4.00

2.00

0.00
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Dividend Rate

European American

Figure 9: Cliquet put option values and the dividend rate

3.2.2.5 Delta Sensitivity to Stock Price Changes

Table 3 reports the deltas of American cliquet and plain vanilla put options as a function
of the underlying stock price. The delta of an option is defined as the rate of change of
the option price with respect to the change in price of the underlying asset price. It is the
slope of the curve that relates the option price to the underlying asset price.

23
 Stock Vanilla Cliquet
0.0 -1.00 -1.00
10.0 -1.00 -1.00
20.0 -1.00 -1.00
30.0 -1.00 -1.00
40.0 -1.00 -1.00
50.0 -1.00 -1.00
60.0 -1.00 -1.00
70.0 -1.00 -1.00
80.0 -0.76 -0.69
90.0 -0.55 -0.44
100.0 -0.40 -0.23
110.0 -0.28 -0.12
120.0 -0.17 -0.01
130.0 -0.11 0.03
140.0 -0.08 0.05
150.0 -0.05 0.06
160.0 -0.03 0.07
170.0 -0.02 0.07
180.0 -0.01 0.07
190.0 -0.01 0.07
200.0 0.00 0.07

Table 3: Deltas of American cliquet and plain vanilla put options

For low stock prices (below $70), delta is greatest in absolute value. Delta is negative,
which means that a long position in a put option should be hedged with a long position in
the underlying asset. A delta of -1 means that when the stock price changes by a small
amount the option price changes by 100% of that amount, meaning by the same amount.
This is to be expected of a deep in-the-money American put, because the holder can
exercise the option immediately and gain the entire price change.

24
For deep in-the-money European put options, the delta is -0.951, close to -1, but because
there is no early exercise opportunity, there is still a slight chance the European put will
mature out-of-the-money.

The delta of the standard put is zero for any stock price beyond $200. At this point it is
quite certain that the plain vanilla put will be maturing out-of-the-money. Therefore,
small changes in the stock price do not effect the put price. Conversely, the cliquet is
almost certain to reset at high stock prices, $120 and beyond, therefore its delta is
positive. Since the cliquet reset mechanism resets the exercise price to the current stock
price, increases in stock price mean the cliquet is bound to be increasingly in-the-money
upon reset. Therefore, small positive price changes in the underlying stock have a
positive affect on the cliquet value.

Figure 10 is a graphic representation of the American cliquet and plain vanilla put deltas.

Delta Sensitivity to Stock Price

0.20

0.00
0.00 50.00 100.00 150.00 200.00 250.00
-0.20

-0.40
Delta

-0.60

-0.80

-1.00

-1.20
Current Stock Price
Vanilla Delta Cliquet Delta

Figure 10: Deltas of American plain vanilla and cliquet put options

25
Figure 11 shows the delta sensitivity of American plain vanilla and cliquet call options.
For very low stock prices (below $40) delta is zero for the plain vanilla call. Maturing
out-of-the-money is inevitable in this case, therefore a small change in the stock price
does not have any effect on the call price. Conversely, cliquet options are certain to reset
if the stock price is low, therefore they maintain a positive delta.

For stock prices ranging between $170 and $70, the plain vanilla deltas are higher than
the cliquet’s. As the stock price falls, the cliquet is certain to reset, therefore it is less
sensitive to changes in price. Another way of looking at this is that the reset opportunity
grants the holder a form of insurance. Therefore hedging needed for the cliquet option
position is limited, relative to a standard option. The number of shares required to sell
short in order to hedge a long position in a plain vanilla option is greater because the
plain vanilla option does not incorporate any type of insurance.

At $150 and beyond, the delta measures for both option types converge. When the stock
price increases well beyond the exercise price, the reset opportunity becomes valueless,
and the cliquet acts like a standard call option. The call option is deep in-the-money;
there is no gain by resetting the exercise price.

Delta Sensitivity to Stock Price

1.00

0.90
0.80

0.70
0.60
Delta

0.50
0.40

0.30
0.20

0.10
0.00
0.00 50.00 100.00 150.00 200.00 250.00
Current Stock Price
Vanilla Delta Cliquet Delta

Figure 11: Deltas of American plain vanilla and cliquet call options

26
In this section we presented some characteristics of the cliquet option behavior and
compared them to those of plain vanilla. More analyses and comparisons are possible,
and you are welcome to view them by using our “Backward_CRR_Cliquets_Analysis”
file.

3.3 Monte Carlo Simulation

Probably the most popular method for exotic options pricing today is Monte-Carlo
simulation. Monte-Carlo is most commonly used when there's a path dependency
property required to determine the final payoff, as in Asian options, barrier options, our
cliquet options and many other exotics.

The greatest advantage of using MC simulation, as opposed to closed-form solutions and

other numerical and analytical approaches, is its tremendous flexibility. It is possible to
adjust Monte-Carlo simulation to price almost any kind of exotic. The different cliquet
option types mentioned above (including multiple reset dates) could be priced using MC
simulation. The adjustment needed for each different cliquet type can be made in no
time. With today's variety of exotics, and the rate at which new ones are invented, this
approach gives the fastest answer to the demand for new options valuation.

However, there are many tradeoffs involved in using MC simulations. Among the
disadvantages of Monte-Carlo:
The inability to value American options (though there're several approaches that deal
with this problem).
Relatively poor accuracy on one hand, and an extremely large number of calculations
needed to reach a good accuracy, on the other.

27
Our Monte-Carlo simulation implementation is straight forward. As in previous sections
we assume U = e σ ∆t
and D = e −σ ∆t
, the adjusted risk-neutral probability for up state is
e b ∆t − D
p= and (1-p) for down state.
U −D

At each time step a number between 0 and 1 is drawn at random from a uniform
distribution. If this number is less than p, the stock takes an up step, if the random
number is larger than p, the stock goes down one step. On the reset day m, the new strike
is determined and the stock price continues its random walk. On the maturity date n, the
payoff is determined and discounted by the risk-free rate to get its present value. The
procedure repeats itself a number of times (5,000 works good enough). Then, a simple
arithmetic average of all discounted payoffs is calculated, and this is a European cliquet
value under Monte-Carlo valuation.

Table 1Table 4 compares the results of our backward cliquet valuation binomial
approach, introduced in the previous section, with the results of the Monte-Carlo
simulations.

The parameters used are S=100, X=100, T=1, r=10%, div=0%, σ=30%, n=200, number
of runs for each simulation = 56,000. Tau is years to reset. Of course, these cliquets are
European.

tau=0.25 tau=0.50 tau=0.75

Volatility Backward CRR M-C Backward CRR M-C Backward CRR M-C
Call
0.1 10.921 10.915 10.823 10.827 10.647 10.659
0.2 14.569 14.571 14.552 14.550 14.257 14.243
0.3 18.587 18.591 18.653 18.686 18.287 18.287
Put
0.1 1.161 1.165 1.363 1.360 1.484 1.480
0.2 4.933 4.933 5.315 5.307 5.358 5.362
0.3 9.255 9.271 9.790 9.792 9.730 9.724

Table 4: Model Comparison

28
It can be clearly seen from the table that Monte-Carlo simulation gives values that are
very close to our CRR based backward cliquet pricing model (to obtain this accuracy we
waited quite a long time for all calculations). Of course, each simulation will produce
slightly different numbers.

The Monte Carlo simulation function can be found in the “MC_Cliquet” Excel file.

29
4 Excel

4.1 Adjusted Risk-Neutral Probabilities Binomial Valuation

We implement our adjusted HH model extension in Excel file "Adjusted_HH_Cliquet".

The following is a screen shot of this excel file.

Our VBA function for the extended HH pricing method is:

=AdjEuroCliquet(Call_Put,S,X,T,t_reset,rf,div,sigma,n)
This function yields the results shown in cell B23.

In this spreadsheet we also compare our results to those of GW and HH’s original model.
Their functions are:
=ResetOption(Call_Put, S, X, rf, div, t_reset, T,sigma)

30
and
=HHEuroCliquet(Call_Put,S,X,T,t_reset,rf,div,sigma,n)
respectively.

The GW function was written by Kevin Cheng and was sent to us, following our request,
by www.global-derivatives.com.

The HH function was sent to us by Espen G. Haug, but may also be found on the
www.global-derivatives.com site.

The "Adjusted_HH_Cliquet” spreadsheet also has the results for plain vanilla Black-
Scholes and Cox-Ross-Rubinstein options pricing.

The Black-Scholes function is '=BSVanilla(Call_Put,S,X,T,rf,sigma)' and was taken from

Benninga (2001).

The CRR Vanilla pricing function code may be found in Haug (1997). We called their
function: '=CRRVanilla(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n)'

The VBA code for our extended HH cliquet pricing model function,
'=AdjEuroCliquet(Call_Put,S,X,T,t_reset,rf,div,sigma,n)', is as follows:

'Binomial model for pricing European reset options with risk-neutral probabilities

Public Function AdjEuroCliquet(CallPutFlag As String, S As Double, _

X As Double, T As Double, tau As Double, r As Double, _
div As Double, sigma As Double, n As Integer) As Double

Dim OptionValue As Double

Dim U As Double, D As Double, PathProb As Double
Dim dt As Double, Df As Double, Stau As Double, StLast As Double
Dim a As Double, p As Double

31
Dim i As Integer, j As Integer, z As Integer, m As Integer, m1 As Double
Dim StartNode As Integer, EndNode As Integer

If CallPutFlag = "Call" Then ' call option

z=1
Else ' put option
z = -1
End If

dt = T / n
U = Exp(sigma * Sqr(dt))
D=1/U
a = Exp((r - div) * dt) 'the cost of carry term
p = (a - D) / (U - D) 'risk-neutral UP probability
m1 = tau / dt
m = Int(m1)

OptionValue = 0

For j = 0 To m

'calculating stock prices at the reset date

Stau = S * U ^ j * D ^ (m - j)

StartNode = j
EndNode = n - m + j

For i = StartNode To EndNode

'calculating stock prices at the maturity date
StLast = S * U ^ i * D ^ (n - i)

'calculating payoff probabilities

PathProb = (Application.Fact(m) * Application.Fact(n - m)) / _
(Application.Fact(j) * Application.Fact(m - j) * _
Application.Fact(i - j) * Application.Fact(n - m - i + j)) * _
p ^ i * (1 - p) ^ (n - i)

32
 'calculating expected payoffs
OptionValue = OptionValue + PathProb * _
Application.Max(z * (StLast - X), z * (StLast - Stau), 0)
Next
Next

AdjEuroCliquet = Exp(-r * T) * OptionValue 'discounting

End Function

Note that the payoff is determined by "Application.Max(z * (StLast - X), z * (StLast - Stau), 0)",
which corresponds to both call payoff, Max( Su i d n −i − X , Su i d n −i − Su j d m − j ,0) , and put
payoff, Max( X − Su i d n −i , Su j d m − j − Su i d n −i ,0) . The use of the Boolean variable z (which is
set to 1 for call and -1 for put) helps prevent unnecessary "IF... THEN..." checks.
As follows from the spreadsheet, our values are very close to those of GW and the ones
of HH.

33
4.2 Backward Valuation Binomial Approach

Our function '=CRRCliquet(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n,m)' is the VBA

implementation of the binomial backward valuation cliquet pricing method, introduced in
chapter 3.2.1. Here's the function's code:

Function CRRCliquet(AmeEurFlag As String, CallPutFlag As String, S0 As Double, _

X0 As Double, T As Double, r As Double, div As Double, sigma As Double, _
n As Integer, m As Integer) As Double
'Our Backward Valuation Cliquet Options Pricing Model Based On
'Cox-Ross-Rubinstein Binomial Tree

Dim OptionValue() As Double, St() As Double, Xnew() As Double

Dim U As Double, D As Double, p As Double
Dim dt As Double, Df As Double, a As Double
Dim Treset As Double, nreset As Integer
Dim i As Integer, j As Integer, z As Integer

ReDim OptionValue(n + 1)
ReDim St(m + 1)
ReDim Xnew(m + 1)

If CallPutFlag = "Call" Then

z=1
ElseIf CallPutFlag = "Put" Then
z = -1
End If
dt = T / n
U = Exp(sigma * Sqr(dt))
D=1/U

Treset = (n - m) * T / n 'time from reset to maturity

nreset = n - m 'number of steps from reset to maturity

'Option valuation at reset date at each stock price node

34
For i = 0 To m
St(i) = S0 * U ^ i * D ^ (m - i) 'stock prices at reset date
Xnew(i) = z * Min(z * St(i), z * X0) 'new strike after reset
'at reset time vanillas values with n-m steps to maturity
OptionValue(i) = CRRVanilla(AmeEurFlag, CallPutFlag, St(i), Xnew(i), Treset, r, div, sigma, nreset)
Next i

a = Exp((r - div) * dt) 'cost of carry term

p = (a - D) / (U - D) 'risk-neutral UP probability
Df = Exp((-r) * dt)

'Backwards option valuation

For j = m - 1 To 0 Step -1
For i = 0 To j
If AmeEurFlag = "E" Then
OptionValue(i) = (p * OptionValue(i + 1) + (1 - p) * OptionValue(i)) * Df
ElseIf AmeEurFlag = "A" Then
OptionValue(i) = Max((z * (S0 * U ^ i * D ^ (j - i) - X0)), _
(p * OptionValue(i + 1) + (1 - p) * OptionValue(i)) * Df)
End If
Next i
Next j
CRRCliquet = OptionValue(0)
End Function

The algorithm for this pricing technique is explained in section 3.2.1.

Note the use of the Boolean variable z when determining the new strike at the reset date:
Xnew(i) = z * Min(z * St(i), z * X0)
This allows the strike to reset for both calls and puts without using an extra IF... THEN...
statement.

Another very useful "trick" in the function code is the use of Min() and Max() functions,
we programmed in the VBA module:
Function Max(X1 As Double, X2 As Double)
Max = X1
If (X2 > X1) Then Max = X2

35
End Function
--------------------------------------------------------
Function Min(X1 As Double, X2 As Double)
Min = X1
If (X2 < X1) Then Min = X2

End Function

The Min() and Max() functions speed up calculations tremendously compared to the
Application.Max() and Application.Min() functions.

The '=CRRCliquet(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n,m)' function output is shown

below, on the "Backward_CRR_Cliquet" Excel spreadsheet screen shot (cell B20). In
this spreadsheet you can also see the plain vanilla value as calculated by the CRR
binomial method (=CRRVanilla(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n) function in
B19).

Note that as previously mentioned, this method is preferable to the HH model:

36
 • American cliquets can be priced using this formula.
• More than 196 time steps can be used, because there are no factorials and big
numbers. For instance, it'll take a couple of minutes to calculate the cliquet value
using n=1,000 time steps, which is extremely close to the continuous model.
(Obviously, the run-time depends on you computer capabilities).
• This method also gives us the ability to run sensitivity analysis for different types
of cliquets and to compare the results (European vs. American, vanilla vs. cliquet,
put vs. call). Section 3.2.2 shows some of these analyses using the Excel file
"Backward_CRR_Cliquet_Analysis" (for an explanation, see Chapter 4.5).

In this spreadsheet we also provided Delta calculation functions:

=DeltaVanilla(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n)
and
=DeltaCliquet(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n,m)
for CRR vanillas and cliquets respectively.

The functions' code is:

Function DeltaVanilla(AmeEurFlag As String, CallPutFlag As String, S0 As Double, X0 As Double, _
T As Double, r As Double, div As Double, sigma As Double, n As Integer) As Double
DeltaVanilla = (CRRVanilla(AmeEurFlag, CallPutFlag, S0 + 0.001, X0, T, r, div, sigma, n) - _
CRRVanilla(AmeEurFlag, CallPutFlag, S0, X0, T, r, div, sigma, n)) / 0.001
End Function
------------------------------------------
Function DeltaCliquet(AmeEurFlag As String, CallPutFlag As String, S0 As Double, X0 As Double, _
T As Double, r As Double, div As Double, sigma As Double, n As Integer, m As Integer) As Double
DeltaCliquet = (CRRCliquet(AmeEurFlag, CallPutFlag, S0 + 0.001, X0, T, r, div, sigma, n, m) - _
CRRCliquet(AmeEurFlag, CallPutFlag, S0, X0, T, r, div, sigma, n, m)) / 0.001
End Function

We use these functions for the sensitivity and comparison analysis in section 3.2.2.

37
4.3 Monte Carlo Simulation for European Cliquet Options Valuation

Our Monte Carlo method is discussed in section 3.3. Here's the VBA code for our
simulation function ' =EuroCliquetMC(Call_Put,S,X,T,rf,div,sigma,n,m,runs)':

Function EuroCliquetMC(CallPutFlag As String, S0 As Double, X0 As Double, T As Double, _

r As Double, div As Double, sigma As Double, n As Integer, m As Integer, runs As Integer) As Double
'Our Cliquet Options Pricing Binomial Monte-Carlo Simulation Model

Dim Price() As Double, TotalOption As Double

Dim OptionValue As Double, Xnew As Double
Dim U As Double, D As Double, p As Double
Dim dt As Double, a As Double
Dim i As Integer, ind As Integer, z As Integer
ReDim Price(n + 1)

If CallPutFlag = "Call" Then

z=1
ElseIf CallPutFlag = "Put" Then
z = -1
End If

dt = T / n
U = Exp(sigma * Sqr(dt))
D=1/U
a = Exp((r - div) * dt)
p = (a - D) / (U - D)
TotalOption = 0

For ind = 1 To runs

'price path generation
For i = 1 To n
Price(0) = S0
'UP/Down determining
If Rnd < p Then

38
 Price(i) = Price(i - 1) * U
Else
Price(i) = Price(i - 1) * D
End If
Next i
'Strike reset
Xnew = z * Min(z * Price(m), z * X0)
'option value in one simulation
OptionValue = Max(0, z * (Price(n) - Xnew))
'sum of option values in all simulations
TotalOption = TotalOption + OptionValue
Next ind
'average cliquet discounted value
EuroCliquetMC = (TotalOption * Exp(-r * T)) / runs
End Function

As mentioned above, although this model prices only European cliquets and is not as
accurate as our backward valuation method, the MC simulation is the most flexible
model, allowing quick adjustments for pricing many exotic option types.

The screen shot of the "MC_Cliquet" Excel file is shown below:

39
For Monte Carlo simulations we can do simple statistics analysis (rows 30-33).
Note that the average result of these 56 Monte-Carlo simulations (cell B17) is very close
to that obtained from our backward valuation model (cell B18), while the standard
deviation is very low. Of course, each run will yield a different result, but note that the
max-min range (cells C31:C32) is very small.

4.4 Pricing Model Comparison

Our Excel file "Model_Comparison" includes different option pricing models so it is easy
to compare different model outcomes. The results of the three valuation methods we
developed and described in Chapter 3 are shown in cells B21, B23 and B26.

40
4.5 Sensitivity Analyses Using Our Backward Valuation Approach

As previously mentioned, one of the advantages of our backward valuation cliquet

pricing method is that it allows different sensitivity analyses and comparison of different
types of options (European vs. American, vanilla vs. cliquet, put vs. call).

For these purposes we made an Excel file "Backward_CRR_Cliquet_Analysis". The

analyses are based on our "=CRRCliquet(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n,m)"
formula and also on the plain vanilla CRR pricing formula explained above,
'=CRRVanilla(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n)'.

The file is produced for the purpose of conducting sensitivity analyses alone and includes
rather heavy calculations.

41
The following example illustrates how to best use the spreadsheet. If we wish to analyze
and compare the cliquet and standard option sensitivities to changes in spot stock prices,
we click the button next to the “Initial Stock Price”, cell C6. Allow the program a minute
or two to do the data table calculations (we recommend using 100 time steps (n=100) and
allow for approx. 1 minute calculations). After the calculations are completed the results
are displayed on the chart in the spreadsheet. To compare different option types, simply
click one of the buttons located below, for instance AmerCall, AmerPut, Cliquet Put, etc.
The chart will update itself immediately. Note that the chart title changes also, so you
can see the analysis type on the chart. Following is a screen shot of the sensitivity
analysis spreadsheet:

In this file you can also conduct delta analyses. For this purpose we use the delta
functions:
=DeltaVanilla(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n)
and
=DeltaCliquet(Ame_Eur,Call_Put,S,X,T,rf,div,sigma,n,m)

42
for CRR Vanillas and our cliquets respectively. Those functions were introduced earlier.
The delta comparison chart is located lower on the spreadsheet, as can be seen in the
following screen shot:

43
5 Conclusion

In this paper we developed three valuation methods to price cliquet options.

The first method is an extension of the HH European cliquet pricing model, where the
risk-neutral probabilities are calculated according to the CRR assumptions.

The second method, based on CRR backward binomial valuation, makes up the principal
part of the paper. We used the CRR valuation method, usually used to price plain vanilla
options, to price cliquet options. This method enabled us to price American cliquet
options, which is not possible under the HH method. We were also able to conduct
sensitivity analyses of cliquet option behavior with respect to a multitude of parameters.

The third method introduced is a Monte Carlo simulation approach for cliquet pricing.

Further research of cliquet option pricing techniques may include adjusting our models
for pricing different types of cliquets, such as multiple period reset compound cliquets,
cliquet options with caps and floors, and others.

Another interesting research task would be to compare our models’ results with actual
market data. The main challenge is to locate these data since most cliquets are traded on
OTC markets.

44
6 Bibliography

Benninga, Simon. Financial Modeling. Cambridge: The MIT Press, 2001.

Buetow, Gerald W. Jr. “Ratchet Options.” Journal of Financial Strategic Decisions 12 2

(1999): 17-30.

Cox, John C., Stephen Ross, and Mark Rubinstein. "Option Pricing: A Simplified
Approach." Journal of Financial Economics 7 (October 1979): 229-264.

Gray Stephen F. and Robert E. Whaley. “Reset put options: Valuation, Risk
Characteristics and Application.” Australian Journal of Management 24 1
(June 1999): 1-20.

Gray Stephen F. and Robert E. Whaley, “Valuing S&P 500 Bear Market Warrants with a
Periodic Reset.” Journal of Derivatives 5, 1 (Fall 1997): 99-106.

Haug, Espen Gaarder. The Complete Guide to Option Pricing Formulas. McGraw-Hill,
1997.

Haug Espen and Jorgen Haug. “The Collector: Who’s On First Base?” Wilmott
Magazine (2001) <http://www.wilmottmag.com/detail.cfm?articleID=39>.

Hull, John C. Options, Futures, and Other Derivatives. Saddle River: Prentice Hall,
2003.

Rubinstein, Mark. "Pay Now, Choose Later." RISK 4 (1991): 13.

Schoutens, Wim and Stijn Symens. “The Pricing of Exotic Options by Monte-Carlo
Simulations in a Lévy Market with Stochastic Volatility.” (2002).

45
Wilmott, Paul. “Cliquet Options and Volatility Models” Wilmott Magazine (2001): 78-
83 <http://www.wilmottmag.com/detail.cfm?articleID=183>.

Windcliff, H.A., P.A. Forsyth. and K.R. Vetzal. “Numerical Methods for Valuing
Cliquet Options.” (2003).

46