Asian Review of Financial Research Vol.20 No.1 pp.35-76
An Empirical Study on the Pricing Model of Equity Linked Deposit
Key Words : Equity Linked Deposit,Exotic Option,Stochastic Interest Rate
The market for Equity Linked Deposits (ELD) has been rapidly growing in Korea. Most ELDs can be decomposed into two components；straight bond and equity option. The latter is the more important part of the two because it primarily determines the characteristics of an ELD, which are quite different from those of a plain deposit product. The diversity of equity options in ELDs make it difficult for investors to evaluate the value of ELDs. This paper examines pricing models for ELDs based on data on ELDs issued from Mar. 2003 to Dec. 2005. The option features in ELDs covered in this study include exotic options like Barrier and Digital options as well as plain vanilla European options. We restrict our attention to products of which underlying assets are Korean equities or equity index. We calculate theoretical prices of ELDs in the primary market and compare them with issue prices to determine which pricing model is suitable for pricing ELDs. For the valuation of options embedded in ELDs, we use both historical and implied volatility estimates and assume stochastic or constant interest rates to see the influence of interest rate assumptions. Under each option pricing assumption, theoretical prices of ELDs are on average below issue prices. The interest rate assumptions have little effect on the price while the implied volatility model is better than the historical one in explaining issue price of ELDs. Also some factors driving the discrepancies between theoretic and issue price are identified. They include type of implicit derivatives, underlying asset, and so on.