Valuation of Variable Annuities with Equity Protection Swaps under Jumps and Default Risks

Abstract

This paper examines the valuation and hedging of standard equity protection swap (EPS) products proposed by Xu et al.. To account for financial crises and counterparty default risk, we develop pricing frameworks based on Merton's jump-diffusion model and Szimayer's independent random time default model, under which closed-form valuation formulas and put-call parity relations for European options are derived. Hedging strategies for EPS products are analysed under jump and default risks. While static hedging remains effective in the absence of default, counterparty default risk leads to residual losses that cannot be fully hedged. These losses are quantified and used to define default-adjusted initial premiums under both Black-Scholes and jump-diffusion settings. Numerical results illustrate the effects of jump characteristics and default intensity on hedging costs and premiums, highlighting the importance of incorporating crisis and credit risks in EPS pricing and risk management.