Financial Engineering Applications of Forward Start Options for Structured Products with Capital Protection

Abstract

Index-linked securities with capital protection have recently been sought by pension funds, institutional investors, hedge funds and other financial institutions looking for downside risk protection while still providing upside equity index participation. The forward start option is the core ingredient for several types of cliquet option that can be integrated into a structured product providing the desired protection of the principal invested. Risk management can be difficult for the issuer and a Monte Carlo exploration reveals some caveats. Pricing forward start options is discussed under the constant-elasticity-of-variance model and new closed formulae are obtained under the square-root process model.