valuing options and guarantees & Q32.9 (i)

[Smith]

Hi there,

frankly to say, I'm always not clearly understand what's the meaning by "valuing options and guarantees" in part 3, Chapter 32. Does it mean for determining a value for provision/reserving for the component? or determining a value for pricing for the component?

in the syllabus objectives of Chapter 32, P1 of the chapter, 11.7.2, point 2, "the reasons why the assumptions and methods used to place a value on guarantees and options may differ from those used for calculating the accounting provisions needed". literally understand it's the difference between pricing and provision/reserving, am i right? otherwise how to understand this syllabus point?

from the content in P12, Chapter 32 valuation of liabilities, a couple of paragraphs beneath the sub-title of "option exercise rate influences", is it saying that assuming the highest cost for provision/reserving, while may hold pretty less cautious assumptions for pricing?

for Q32.9 (i), read the answer, where is the value of the questioned option?

 

[Lindsay Smitherman]

Hi - there are various reasons why you might value options and guarantees, as you suggest. For example, in order to determine what to charge for them in pricing, or what to hold as a provision against them, or for determining the capital requirements to hold in order to support the risks underlying them. The basis chosen will depend on the purpose, the needs of the client, any regulations / legislation etc.

What I think this syllabus objective is getting at is that it might be the case that a prudent accounting or supervisory valuation basis would require an assumption of 100% take-up of an option that is in-the-money. However, if you were doing a realistic valuation (eg for pricing) then you would use a best estimate assumption, which is likely to be <100%. Some of the reasons why this is the case are set out in the section with the heading that you mention here.

 

[Lindsay Smitherman]

for Q32.9 (i), read the answer, where is the value of the questioned option?

The question is asking for the 'equation of value' for an option to commute a pension for a lump sum payment. In other words, it is asking for the equation which would determine how much lump sum to offer for a specific amount of commuted pension. This is what is then stated in the solution.

 

[Smith]

understood, thanks a lot!