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longevity_swaps - U NIVERSITY OF E SSEX D EPARTMENT OF E...

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U NIVERSITY OF E SSEX D EPARTMENT OF E CONOMICS EC372 Economics of Bond and Derivatives Markets Longevity Swaps – an Emerging Market As with most swap contracts, a longevity swap comprises the exchange of a fixed se- quence of payments for a ‘floating’ sequence. What distinguishes longevity swaps is that the floating payments vary with the length of life (longevity) of a well-defined population group. The simplest example – unrealistic but capturing the crucial feature – is of a swap for which the ‘floating’ payment is a life-time annuity paid to a specific individual (i.e. a pension). Although the payments may be constant across time (perhaps they are adjusted for inflation), the sequence is ‘floating’ in the sense that the payments cease when the individual (the annuitant) dies. Thus, the annuitant, I , might be a 60-year old individual who receives £ 25 , 000 each year. These payments represent the floating sequence. The fixed sequence would be an amount £ N for, say, 15 years. What determines N ? Presumably this depends on the ex- pected life of the annuitant and the objectives of the parties (most importantly, their respec- tive attitudes to risk), A and B to the swap. Suppose that A agrees to pay £ N = £ 28 , 000 per annum to B for 15 years, in exchange for the annuity. If I dies younger than 75 (= 60 + 15) , then B clearly gains, but if I survives longer, then A may gain – depending on when I dies relative to the Net Present Value of £ 3 , 000 (= 28 , 000 - 25 , 000) for the 15 years of the swap.
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