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

Abstract

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

Baule, Rainer, Credit Risk in Derivative Securities - A Simplified Approach (January 02, 2021). Journal of Futures Markets, forthcoming, Available at SSRN: https://ssrn.com/abstract=3519135 or http://dx.doi.org/10.2139/ssrn.3519135

Rainer Baule (Contact Author)

University of Hagen ( email )

Universitaetsstrasse 41
Hagen, 58097
Germany

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