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A jump-diffusion approach to modelling vulnerable option pricing

Author

Listed:
  • Xu, Weidong
  • Xu, Weijun
  • Li, Hongyi
  • Xiao, Weilin

Abstract

Following the framework of Klein [1996. Journal of Banking and Finance 20, 1211–1229], this paper presents an improved method of pricing vulnerable options under jump diffusion assumptions about the underlying stock prices and firm values which are appropriate in many business situations. In contrast to Klein [1996. Journal of Banking and Finance 20, 1211–1229] model, jumps can be used to model sudden changes in stock prices and firm values. Further, with the jump risk, a firm can default instantaneously because of an unexpected drop in its value. Therefore, our model is able to provide sufficient conceptual insights about the economic mechanism of vulnerable option pricing. The numerical results show that a jump occurrence in firm values can increase the likelihood of default and reduce the vulnerable option prices.

Suggested Citation

  • Xu, Weidong & Xu, Weijun & Li, Hongyi & Xiao, Weilin, 2012. "A jump-diffusion approach to modelling vulnerable option pricing," Finance Research Letters, Elsevier, vol. 9(1), pages 48-56.
  • Handle: RePEc:eee:finlet:v:9:y:2012:i:1:p:48-56
    DOI: 10.1016/j.frl.2011.07.001
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    References listed on IDEAS

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    Cited by:

    1. repec:cys:ecocyb:v:50:y:2017:i:1:p: is not listed on IDEAS
    2. Lihua Zhang & Weiguo Zhang & Weijun Xu & Xiang Shi, 2014. "A Modified Least-Squares Simulation Approach to Value American Barrier Options," Computational Economics, Springer;Society for Computational Economics, vol. 44(4), pages 489-506, December.
    3. Wang, Xingchun, 2016. "Pricing vulnerable options with stochastic default barriers," Finance Research Letters, Elsevier, vol. 19(C), pages 305-313.
    4. Chen, Son-Nan & Chiang, Mi-Hsiu & Hsu, Pao-Peng & Li, Chang-Yi, 2014. "Valuation of quanto options in a Markovian regime-switching market: A Markov-modulated Gaussian HJM model," Finance Research Letters, Elsevier, vol. 11(2), pages 161-172.

    More about this item

    Keywords

    Vulnerable options; Jump diffusion model; Discrete time model; Credit risk;

    JEL classification:

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

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