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Equity-Indexed Annuity products (EIAs) are becoming increasingly popular as they are accumulation vehicles that offer participation in the equity market growth while keeping the initial capital protected. This paper focuses in particular on a special type of EIAs; the Compound Ratchet (CR). Sellers of this product retain the right to change one of the pricing parameters on each contract anniversary date while promising not to cross a certain predetermined threshold. Changing these parameters can sometimes have an impact on the value of the EIA, which makes them interesting to study. In order to reproduce the pattern of these changing parameters, a new approach of dynamically hedging the CR EIA and simultaneously protecting the issuer from hedging risk is proposed and tested. Trading can only be done in discrete time, which produces hedging errors. Therefore, the new approach is applied to transfer these errors from the issuer to the buyer by dynamically changing the pricing parameters. The distribution of these parameters is extracted and analyzed.

Dynamic Hedging Strategies Based on Changing Pricing Parameters for Compound Ratchets