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The Valuation of Options on Bonds with Default Risk

Author

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  • Riadh Belhaj

    (Conservatoire National des Arts et Metiers, France)

Abstract

In this paper we present a model for valuing European and American options, which incorporates both default and interest rate risks. We develop a framework that permits evaluation of three kinds of options: (i) options issued by default-free counterparties on risky bonds, (ii) options issued by risky counterparties on default-free bonds and (iii) options issued by risky counterparties on risky bonds — a case where default risk enters at both levels. We show that the price of a put option on a risky discount bond is hump shaped for a European put and monotone increasing for an American put. We also find that the price impact of default risk is less for an American put option than for a European one.

Suggested Citation

  • Riadh Belhaj, 2006. "The Valuation of Options on Bonds with Default Risk," Multinational Finance Journal, Multinational Finance Journal, vol. 10(3-4), pages 277-306, September.
    • Handle: RePEc:mfj:journl:v:10:y:2006:i:3-4:p:277-306
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    References listed on IDEAS

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    Cited by:

    1. Ariful Hoque & Felix Chan & Meher Manzur, 2009. "Modeling Volatility in Foreign Currency Option Pricing," Multinational Finance Journal, Multinational Finance Journal, vol. 13(3-4), pages 189-208, September.

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    More about this item

    Keywords

    option pricing; default risk; defaultable bonds; vulnerable options;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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