Pricing Using Deflators

Abstract

We will now discuss the use of deflators for the valuation of financial contracts that can be used on many kind of contract, insurance policies and pension plans. Many such contracts contain option features. For example, several life insurance policies contain rate of return guarantees. Pension funds typically aim for full indexation of the benefits to price inflation, but in scenarios where inflation is extremely high or the funding ratio is low, indexation can be reduced or skipped altogether. This type of payout is difficult to value with standard present value calculations, as it is not obvious which discount rate to use. However, the payout of the contract depends on some underlying variable like the stock price or the inflation rate. We can therefore see such contracts as contingent claims, or derivatives.