A cliquet is a sequence of forward-start options — each resetting at a periodic date, buying an ATM option for the next period. The total payout depends on the sequence of periodic returns. Cliquets and their variants (LCGF, Napoleon, reverse cliquet) are the core payoffs in retail-structured products (capital-guaranteed notes, principal-protected investments) sold to retail investors by banks.
The key pricing challenge for cliquets is the forward smile: the implied distribution of future returns, conditional on the current price. Local vol and stochastic vol give different forward smiles, and therefore different cliquet prices — even when they are identically calibrated to today's vanilla options. This topic makes that difference precise and quantifies the model risk embedded in structured product books.
By the end of this topic you should be able to:
- price a digital cliquet and a LCGF cliquet under local vol and stochastic vol;
- explain why local vol and stochastic vol disagree on cliquet prices;
- describe the Napoleon option and reverse cliquet payoff structures;
- articulate the model risk problem for an exotic desk hedging a structured product book.
In this lesson
- Contents
- The big picture
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