An OTC option that belongs to the class of correlation derivatives, and which represents a European-style derivative with a payoff function equal to the product of a standard equity put option and an interest rate floorlet. Traffic-light options were designed to provide protection against simultaneous declines in interest rates and equity values. A non-zero payoff can be obtained if and only if both the interest rate and the equity portfolio value are below their respective strike levels at the maturity date.
This option was developed independently by a number of London-based investment banks to fulfill the needs of Danish Life and Pension companies which had to comply with the traffic-light solvency stress tests introduced by the Danish Financial Supervisory Authority in June 2001. These companies were required to submit regular reports illustrating the sensitivity of the companies’ base capital to certain pre-defined market shocks, known as the red and yellow light scenarios. Therefore, traffic-light options were meant to pay off and preserve sufficient capital when interest rates and stock prices fall simultaneously.
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