Dam Rain and Cumulative Gain

TL;DR

This paper develops a model for pricing financial contracts based on cumulative gains processes, providing explicit formulas and leveraging gamma bridge properties, applicable to insurance, credit, pensions, and environmental assets.

Contribution

It introduces a novel explicit valuation framework for assets linked to cumulative gains, utilizing gamma bridge processes for a wide range of financial products.

Findings

Explicit value process formulas derived

Closed-form prices for European options obtained

Gamma bridge properties are key to the model

Abstract

We consider a financial contract that delivers a single cash flow given by the terminal value of a cumulative gains process. The problem of modelling and pricing such an asset and associated derivatives is important, for example, in the determination of optimal insurance claims reserve policies, and in the pricing of reinsurance contracts. In the insurance setting, the aggregate claims play the role of the cumulative gains, and the terminal cash flow represents the totality of the claims payable for the given accounting period. A similar example arises when we consider the accumulation of losses in a credit portfolio, and value a contract that pays an amount equal to the totality of the losses over a given time interval. An explicit expression for the value process is obtained. The price of an Arrow-Debreu security on the cumulative gains process is determined, and is used to obtain a closed-form expression for the price of a European-style option on the value of the asset. The results obtained make use of various remarkable properties of the gamma bridge process, and are applicable to a wide variety of financial products based on cumulative gains processes such as aggregate claims, credit portfolio losses, defined-benefit pension schemes, emissions, and rainfall.