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Pricing Vulnerable Options with Copulas

  • Umberto Cherubini
  • Elisa Luciano

    ()

In this paper we apply a copula function pricing technique to the evaluation of vulnerable options, i.e. options with counterpart risk. Using copulas enables to separate the specification of marginal distributions and the dependence structure of the events of exercise of the option and default of the counterpart. Our proof that counterpart risk is evaluated as a copula function is based on no-arbitrage arguments only. This makes our results directly applicable to incomplete market models. Also, the no-arbitrage arguments provide easy-to-implement super-replication strategies. We study digital, call and put options with counterpart risk. Furtehr, we price a credit derivative contract, namely a default put option. We calibrate the models on real market data, using a mixing copula, which provides closed form pricing formulas.

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File URL: http://servizi.sme.unito.it/icer_repec/RePEc/icr/wp2002/luciano06-02.pdf
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Paper provided by ICER - International Centre for Economic Research in its series ICER Working Papers - Applied Mathematics Series with number 06-2002.

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Length: 37 pages
Date of creation: Jan 2002
Date of revision:
Handle: RePEc:icr:wpmath:06-2002
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  1. Umberto Cherubini & Elisa Luciano, 2002. "Multivariate Option Pricing with Copulas," ICER Working Papers - Applied Mathematics Series 05-2002, ICER - International Centre for Economic Research.
  2. Umberto Cherubini & Giovanni Della Lunga, 2001. "Liquidity and credit risk," Applied Mathematical Finance, Taylor & Francis Journals, vol. 8(2), pages 79-95.
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