Pricing Vulnerable Black-Scholes Options With Dynamic Default Barriers

8 Pages Posted: 9 May 2007

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

H. C. Lee

Department of Physics

Abstract

The "structural approach" to modeling credit risk specifies a stochastic process that the net asset value of the issuing firm is assumed to follow. If firm value falls below a certain "default barrier," bankruptcy is triggered and the firm is assumed to default on its vulnerable obligations. In this article, Hui, Lo, and Lee apply the methodology to price vulnerable options written by a default risky firm. They show how a variety of default scenarios may be accommodated by use of a dynamic default barrier, while maintaining a closed-form valuation equation.

Keywords: Option pricing, Credit risk, Derivatives

JEL Classification: G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Lee, H. C., Pricing Vulnerable Black-Scholes Options With Dynamic Default Barriers. Journal of Derivatives, Vol. 10. No. 4, pp. 62-69, 2003. Available at SSRN: https://ssrn.com/abstract=984810

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

H. C. Lee

Department of Physics ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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