Pricing of Traffic Light Options and other Correlation Derivatives

This paper considers derivatives with payo¤s that depend on a stock index and underlying LIBOR rates. A tra¢ c light option pricing formula is derived un- der lognormality assumptions on the underlying processes. The tra¢ c light option is aimed at the Danish life and pension sector to help companies stay solvent in the tra¢ c light stress test system introduced by the Danish Financial Supervisory Authorities in 2001. Similar systems are now being implemented in several other European countries. A pricing approach for general payo¤s is presented and illustrated with simulation via the pricing of a hybrid derivative known as the EUR Sage Note. The approach can be used to price many existing structured products.