IDEAS home Printed from https://ideas.repec.org/a/eee/phsmap/v672y2025ics0378437125002985.html
   My bibliography  Save this article

Vulnerable power exchange options with liquidity risk

Author

Listed:
  • 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
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0378437125002985
    Download Restriction: Full text for ScienceDirect subscribers only. Journal offers the option of making the article available online on Science direct for a fee of $3,000
    File URL: https://libkey.io/10.1016/j.physa.2025.130646?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:phsmap:v:672:y:2025:i:c:s0378437125002985. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.