Pricing Vulnerable European Options With Stochastic Default Barriers

IMA Journal of Management Mathematics, Vol. 18, No. 4, pp. 315-329, 2007

15 Pages Posted: 31 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

K. C. Ku

The Chinese University of Hong Kong (CUHK)

Abstract

This paper develops a valuation model of European options incorporating a stochastic default barrier, which extends a constant default barrier proposed in the Hull-White model. The default barrier is considered as an option writer's liability. Closed-form solutions of vulnerable European option values based on the model are derived to study the impact of the stochastic default barriers on option values. The numerical results show that negative correlation between the firm values and the stochastic default barriers of option writers gives material reductions in option values where the options are written by firms with leverage ratios corresponding to BBB or BB ratings.

Keywords: option pricing, credit risk, derivatives

JEL Classification: G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Ku, K. C., Pricing Vulnerable European Options With Stochastic Default Barriers. IMA Journal of Management Mathematics, Vol. 18, No. 4, pp. 315-329, 2007. Available at SSRN: https://ssrn.com/abstract=988850

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

K. C. Ku

The Chinese University of Hong Kong (CUHK) ( email )

Shatin, N.T.
Hong Kong
Hong Kong

Register to save articles to
your library

Register

Paper statistics

Downloads
144
Abstract Views
557
rank
200,927
PlumX Metrics