The volatility target effect in investment-linked products with embedded American-type derivatives

Abstract

Volatility Target (VolTarget) strategies as underlying assets for options embedded in investment-linked products have been widely used by practitioners in recent years. Available research mainly focuses on European-type options linked to VolTarget strategies. In this paper, VolTarget-linked options of American type are investigated. Within the Heston stochastic volatility model, a numerical study of American put options, as well as American lookback options linked to VolTarget strategies, is performed. These are compared with traditional American-type derivatives linked to an equity index. The authors demonstrate that using a Volatility Target strategy as a basis for an embedded American-type derivative may make any protection fees significantly less dependent of changing market volatilities. Replacing an equity index with the VolTarget strategy may also result in reducing guarantee fees of the corresponding protection features in a highly volatile market environment.