Credit Risk in Derivative Securities - A Simplified Approach
Journal of Futures Markets, forthcoming
31 Pages Posted: 6 Feb 2020 Last revised: 4 Jan 2021
Date Written: January 02, 2021
The pricing of options and other derivatives which are subject to the default risk of the writer usually requires the calibration of a sophisticated model and substantial effort in determining the input parameters. In empirical research, this effort is often avoided, and a basic approach that assumes independence of credit risk and market risk is applied. In this note, we propose a very simple method to incorporate correlated credit risk in the pricing of vulnerable derivatives. The approach is based on some approximations of more sophisticated models and requires the correlation between the underlying of the derivative and its writer as the only additional input parameter. It is therefore easily applicable and maintains the accuracy of sophisticated models to a large extent, as shown in numerical studies for call options, put options, and discount certificates.
Keywords: certificates, credit risk, option pricing, vulnerable options
JEL Classification: G 13, G 21
Suggested Citation: Suggested Citation