Pricing of Traffic Light Options and Other Correlation Derivatives

This paper considers derivatives with payoffs that depend on a stock index and underlying LIBOR rates. A traffic light option pricing formula is derived under lognormality assumptions on the underlying processes. The traffic light option is aimed at the Danish life and pension sector to help companies stay solvent in the traffic light stress test system introduced by the Danish Financial Supervisory Authorities in 2001. Similar systems are now being implemented in several other European countries.A pricing approach for general payoffs is presented and illustrated with simulation via the pricing of a hybrid derivative known as the EUR Sage Note. The approach can be used to price many existing structured products