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Vulnerable power exchange options with liquidity risk

Author

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  • Mittal, Priya
  • Selvamuthu, Dharmaraja

Abstract

Modeling the impact of liquidity risk and counterparty default risk on power exchange options is a crucial problem in finance. This paper presents a stochastic model that considers these risks for more accurate pricing of power exchange options. Liquidity risk is considered using a liquidity discount factor, whereas counterparty risk is assessed with firm value models. To derive the pricing formula, the proposed model is transformed into a risk-neutral measure, which is then simplified by applying the Fourier transform to the payoff function and then expressed in terms of the characteristic function. This characteristic function is derived by solving a system of differential equations. To verify the accuracy of the derived pricing formula, a comparison with the simulated option prices is provided. Through numerical analysis, the significance of considering market liquidity and its impact on options prices is illustrated. It has been observed that the liquidity risk increases the options premium. Furthermore, the sensitivity of options prices with respect to various parameters is presented.

Suggested Citation

  • Mittal, Priya & Selvamuthu, Dharmaraja, 2025. "Vulnerable power exchange options with liquidity risk," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 672(C).
    • Handle: RePEc:eee:phsmap:v:672:y:2025:i:c:s0378437125002985
    DOI: 10.1016/j.physa.2025.130646
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