Pricing Vulnerable Options with Copulas
ICER Working Paper, 2001
38 Pages Posted: 21 Feb 2002
Date Written: August 2001
Abstract
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. Further, 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.
Keywords: Credit risk, vulnerable options, copula functions
JEL Classification: G12
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