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Analytically Pricing a Vulnerable Option under a Stochastic Liquidity Risk Model with Stochastic Volatility

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  • Junkee Jeon

    (Department of Applied Mathematics & Institute of Natural Science, Kyung Hee University, Yongin 17104, Republic of Korea)

  • Geonwoo Kim

    (School of Natural Sciences, Seoul National University of Science and Technology, Seoul 01811, Republic of Korea)

Abstract

This paper considers the valuation of a vulnerable option when underlying stock is subject to liquidity risks. That is, it is assumed that the underlying stock is not perfectly liquid. We establish a framework where the stock price follows the stochastic volatility model and the option contains the default risk of the option issuer. In addition, we assume that liquidity risks are caused by stochastic market liquidity, and the default occurs at the first jump time of a stochastic Poisson process, which has a stochastic default intensity process consisting of both idiosyncratic and systematic components. By employing a change of measure, we derive an analytical formula for the value of a vulnerable option. Finally, we present several numerical examples to illustrate the sensitivity of significant parameters.

Suggested Citation

  • Junkee Jeon & Geonwoo Kim, 2024. "Analytically Pricing a Vulnerable Option under a Stochastic Liquidity Risk Model with Stochastic Volatility," Mathematics, MDPI, vol. 12(17), pages 1-16, August.
    • Handle: RePEc:gam:jmathe:v:12:y:2024:i:17:p:2642-:d:1464065
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    References listed on IDEAS

    as
    1. Koo, Eunho & Kim, Geonwoo, 2017. "Explicit formula for the valuation of catastrophe put option with exponential jump and default risk," Chaos, Solitons & Fractals, Elsevier, vol. 101(C), pages 1-7.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515, World Scientific Publishing Co. Pte. Ltd..
    4. Xin‐Jiang He & Sha Lin, 2023. "Analytically pricing exchange options with stochastic liquidity and regime switching," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(5), pages 662-676, May.
    5. Fard, Farzad Alavi, 2015. "Analytical pricing of vulnerable options under a generalized jump–diffusion model," Insurance: Mathematics and Economics, Elsevier, vol. 60(C), pages 19-28.
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