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Valuing Vulnerable Basket Options with Stochastic Liquidity Risk in Reduced-form Models

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  • Bohua Wang

    (School of International Trade and Economics, University of International Business and Economics)

  • Xingchun Wang

    (School of International Trade and Economics, University of International Business and Economics)

  • Mengjie Zhao

    (School of International Trade and Economics, University of International Business and Economics)

Abstract

In this paper, we investigate the pricing problem of vulnerable basket options with stochastic liquidity risk in reduced-form models. We use a liquidity-adjusted model to describe all the underlying asset prices and adopt an intensity-based model to capture default risk. Additionally, we incorporate the correlation between the underlying assets and default risk through the liquidity risk channel. In the proposed framework, we obtain an explicit approximation of vulnerable basket option prices. Finally, we illustrate the effects of liquidity risk and default risk on (vulnerable) basket option prices after checking the accuracy of the approximations.

Suggested Citation

  • Bohua Wang & Xingchun Wang & Mengjie Zhao, 2025. "Valuing Vulnerable Basket Options with Stochastic Liquidity Risk in Reduced-form Models," Computational Economics, Springer;Society for Computational Economics, vol. 66(3), pages 2439-2455, September.
    • Handle: RePEc:kap:compec:v:66:y:2025:i:3:d:10.1007_s10614-024-10794-z
    DOI: 10.1007/s10614-024-10794-z
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