Pricing and hedging guaranteed annuity options via static option replication

In this paper we derive a market value for with-profits guaranteed annuity options (GAOs) using martingale modelling techniques. Furthermore, we show how to construct a static replicating portfolio of vanilla interest rate swaptions that replicates the with-profits GAO. Finally, we illustrate with historical UK interest rate data from the period 1980 to 2000 that the static replicating portfolio would have been extremely effective as a hedge against the interest rate risk involved in the GAO, that the static replicating portfolio would have been considerably cheaper than up-front reserving and also that the replicating portfolio would have provided a much better level of protection than an up-front reserve. (C) 2003 Elsevier B.V. All rights reserved.