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Pricing Vulnerable Options with Constant Elasticity of Variance versus Stochastic Elasticity of Variance

Author

Listed:
  • Min-Ku LEE

    (Department of Mathematics, Kunsan National University Republic of Korea)

  • Sung-Jin YANG, PhD
  • Jeong-Hoon KIM

    (Department of Mathematics, Yonsei University, Seoul, Republic of Korea Republic of Korea)

Abstract

In order to handle option writer’s credit risk, a different underlying price model is required beyond the well-known Black-Scholes model. This paper adopts a recently developed model, which characterizes the 2007-2009 global financial crisis in a unique way, to determine the no-arbitrage price of European options vulnerable to writer’s default possibility. The underlying model is based on the randomization of the elasticity of variance parameter capturing the leverage or inverse leverage effect. We obtain an analytic formula explicitly for the stochastic elasticity of variance correction to the Black-Scholes price of vulnerable options and show how the correction effect is compared with the one given by the constant elasticity of variance model. The result can help to design a dynamic investment strategy reducing option writer’s credit risk more effectively.

Suggested Citation

  • Min-Ku LEE & Sung-Jin YANG, PhD & Jeong-Hoon KIM, 2017. "Pricing Vulnerable Options with Constant Elasticity of Variance versus Stochastic Elasticity of Variance," ECONOMIC COMPUTATION AND ECONOMIC CYBERNETICS STUDIES AND RESEARCH, Faculty of Economic Cybernetics, Statistics and Informatics, vol. 51(1), pages 233-247.
    • Handle: RePEc:cys:ecocyb:v:50:y:2017:i:1:p:
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Vulnerable option; Default risk; Stochastic elasticity of variance; Ornstein-Uhlenbeck process; Monte-Carlo simulation.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C65 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Miscellaneous Mathematical Tools

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