Q&A 7.1 is about designing and pricing a single premium investment bond. The bond offers a return of either: a) a pre determined guaranteed percentage rise in the FTSE 100 index or b) a return of premium if the FTSE-100 has fallen over the policy term. The insurer has an agreement with the merchant bank to provide the guarantee. This has been provided by an amount invested in cash to meet the guaranteed benefit and a call option to buy the rise in the FTSE index. So does this mean that the merchant bank provides the payout on either of the above scenarios or does it just provide the payout on the call option? Do we give the merchant bank a certain amount to invest in cash? Is option a) above a payout of unit fund(which could be less than single premium) plus a % of the increase in the FTSE over the period? If so,could this be a payout of less than single premium if the FTSE did slightly increase over the period? The terms the merchant bank is prepared to offer refers to the participation rate. What is this here? It says the participation rate offered will depend on the percentage of the purchase price that is invested. What do they mean by the percentage of the purchase price invested? Cheers.
My view: An agreement could be setup where the merchant bank pays on either event or on just one of the events. The way the question reads, I would say the merchant bank pays on either event. A premium would be payable to the merchant contract - a bit like an insurance premium, where benefit applicable on event. Option a would give an increase in benefit (so always more than single premium) Not sure by participation rate - I assume it means the amount of % increase in the FTSE it is likely to guarantee depends on the amount paid.
The participation rate is the percentage rise in the FTSE. So we might give 90% of the increase in the FTSE over the term. We must split the premium between cash (to give the guaranteed return of premium) and the put option. The higher the return on cash, the more money we'll have available to buy the option and hence the higher the participation rate we can offer. Best wishes Mark
