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A closed form solution for vulnerable options with Heston’s stochastic volatility

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  • Lee, Min-Ku
  • Yang, Sung-Jin
  • Kim, Jeong-Hoon

Abstract

Over-the-counter stock markets in the world have been growing rapidly and vulnerability to default risks of option holders traded in the over-the-counter markets became an important issue, in particular, since the global finance crisis and Eurozone crisis. This paper studies the pricing of European-type vulnerable options when the underlying asset follows the Heston dynamics. In this paper, we obtain a closed form analytic formula of the option price as a stochastic volatility extension of the classical Heston formula and find how the stochastic volatility effect on the Black–Scholes price as well as on the decreasing speed of the option price with credit risk depends on moneyness.

Suggested Citation

  • Lee, Min-Ku & Yang, Sung-Jin & Kim, Jeong-Hoon, 2016. "A closed form solution for vulnerable options with Heston’s stochastic volatility," Chaos, Solitons & Fractals, Elsevier, vol. 86(C), pages 23-27.
    • Handle: RePEc:eee:chsofr:v:86:y:2016:i:c:p:23-27
    DOI: 10.1016/j.chaos.2016.01.026
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    References listed on IDEAS

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    1. Klein, Peter, 1996. "Pricing Black-Scholes options with correlated credit risk," Journal of Banking & Finance, Elsevier, vol. 20(7), pages 1211-1229, August.
    2. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    3. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. "Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
    4. Johnson, Herb & Stulz, Rene, 1987. "The Pricing of Options with Default Risk," Journal of Finance, American Finance Association, vol. 42(2), pages 267-280, June.
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