Explanation:
Correct answer: B
Acme is a sponsor of a defined benefit pension plan, so it faces longevity risk: if participants live longer than expected, the plan must pay benefits for a longer period.
A good hedge should therefore provide a positive payoff when actual mortality is lower than expected (i.e., when people live longer and realized mortality rates fall below the prespecified level).
A longevity swap with payoff:
will pay Acme when realized mortality is below the prespecified mortality rate, which offsets the pension plan’s longevity losses.
So the best hedge is B.
Q-21.3.3. Acme Industrial Corporate is the plan sponsor for a defined benefit pension plan. At the time of their retirements, participants are promised an annual benefit that is the product of three components: 1.5% * Number of years of service * Average three-year salary. To hedge its exposure to longevity risk, Acme seeks to employ derivatives. Let "MR" represent a mortality rate. Which of the following is the best hedge against Acme's longevity risk with respect to the defined benefit pension plan?
A
A longevity swap where Acme periodically Pays a Fixed premium and Receives Notional Principal × (Realized MR - Prespecified MR)
B
A longevity swap where Acme periodically Pays a Fixed premium and Receives Notional Principal × (Prespecified MR - Realized MR)
C
A longevity option that Acme purchases (long option) and that has a payoff equal to max(0, Realized MR - Prespecified MR)
D
A longevity option that Acme sells/write (short option) and that has a payoff equal to max(0, Prespecified MR - Realized MR)
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