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Analytical pricing of vulnerable options under a generalized jump–diffusion model

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  • Fard, Farzad Alavi

Abstract

In this paper we propose a model to price European vulnerable options. We formulate their credit risk in a reduced form model and the dynamics of the spot price in a completely random generalized jump–diffusion model, which nests a number of important models in finance. We obtain a closed-form price for the vulnerable option by (1) determining an equivalent martingale measure, using the Esscher transform and (2) manipulating the pay-off structure of the option four further times, by using the Esscher–Girsanov transform.

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  • Fard, Farzad Alavi, 2015. "Analytical pricing of vulnerable options under a generalized jump–diffusion model," Insurance: Mathematics and Economics, Elsevier, vol. 60(C), pages 19-28.
    • Handle: RePEc:eee:insuma:v:60:y:2015:i:c:p:19-28
    DOI: 10.1016/j.insmatheco.2014.10.007
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    Cited by:

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    3. Xingchun Wang, 2022. "Valuing fade-in options with default risk in Heston–Nandi GARCH models," Review of Derivatives Research, Springer, vol. 25(1), pages 1-22, April.
    4. Wang, Guanying & Wang, Xingchun & Zhou, Ke, 2017. "Pricing vulnerable options with stochastic volatility," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 485(C), pages 91-103.
    5. F. Antonelli & A. Ramponi & S. Scarlatti, 2021. "CVA and vulnerable options pricing by correlation expansions," Annals of Operations Research, Springer, vol. 299(1), pages 401-427, April.
    6. Xie, Yurong & Deng, Guohe, 2022. "Vulnerable European option pricing in a Markov regime-switching Heston model with stochastic interest rate," Chaos, Solitons & Fractals, Elsevier, vol. 156(C).
    7. Gechun Liang & Xingchun Wang, 2021. "Pricing vulnerable options in a hybrid credit risk model driven by Heston–Nandi GARCH processes," Review of Derivatives Research, Springer, vol. 24(1), pages 1-30, April.
    8. E. Alòs & F. Antonelli & A. Ramponi & S. Scarlatti, 2021. "Cva And Vulnerable Options In Stochastic Volatility Models," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 24(02), pages 1-34, March.
    9. Han, Xingyu, 2018. "Pricing and hedging vulnerable option with funding costs and collateral," Chaos, Solitons & Fractals, Elsevier, vol. 112(C), pages 103-115.
    10. Wang, Xingchun & Zhang, Han, 2022. "Pricing basket spread options with default risk under Heston–Nandi GARCH models," The North American Journal of Economics and Finance, Elsevier, vol. 59(C).
    11. Wenhan Li & Cuixiang Li & Lixia Liu & Mengna Wang, 2021. "Foreign Currency Power Option Pricing Based on Esscher Transform," Computational Economics, Springer;Society for Computational Economics, vol. 58(2), pages 535-548, August.
    12. Alòs, Elisa & Antonelli, Fabio & Ramponi, Alessandro & Scarlatti, Sergio, 2023. "CVA in fractional and rough volatility models," Applied Mathematics and Computation, Elsevier, vol. 442(C).
    13. Junkee Jeon & Geonwoo Kim, 2023. "Valuation of Commodity-Linked Bond with Stochastic Convenience Yield, Stochastic Volatility, and Credit Risk in an Intensity-Based Model," Mathematics, MDPI, vol. 11(24), pages 1-11, December.
    14. Elisa Al`os & Fabio Antonelli & Alessandro Ramponi & Sergio Scarlatti, 2022. "CVA in fractional and rough volatility models," Papers 2204.11554, arXiv.org.
    15. Koo, Eunho & Kim, Geonwoo, 2017. "Explicit formula for the valuation of catastrophe put option with exponential jump and default risk," Chaos, Solitons & Fractals, Elsevier, vol. 101(C), pages 1-7.
    16. Jeon, Jaegi & Kim, Geonwoo & Huh, Jeonggyu, 2021. "An asymptotic expansion approach to the valuation of vulnerable options under a multiscale stochastic volatility model," Chaos, Solitons & Fractals, Elsevier, vol. 144(C).
    17. Geonwoo Kim, 2020. "Valuation of Exchange Option with Credit Risk in a Hybrid Model," Mathematics, MDPI, vol. 8(11), pages 1-11, November.
    18. Antonelli, Fabio & Ramponi, Alessandro & Scarlatti, Sergio, 2022. "Approximate value adjustments for European claims," European Journal of Operational Research, Elsevier, vol. 300(3), pages 1149-1161.
    19. Wang, Heqian & Zhang, Jiayi & Zhou, Ke, 2022. "On pricing of vulnerable barrier options and vulnerable double barrier options," Finance Research Letters, Elsevier, vol. 44(C).
    20. He, Jian & Alavifard, Farzad & Ivanov, Dmitry & Jahani, Hamed, 2019. "A real-option approach to mitigate disruption risk in the supply chain," Omega, Elsevier, vol. 88(C), pages 133-149.
    21. Wang, Xingchun, 2020. "Valuation of Asian options with default risk under GARCH models," International Review of Economics & Finance, Elsevier, vol. 70(C), pages 27-40.
    22. Wang, Xingchun, 2019. "Valuation of new-designed contracts for catastrophe risk management," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).

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    More about this item

    Keywords

    Vulnerable options; Reduced form; Esscher–Girsanov transform; Generalized jump; Credit risk;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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