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Pricing vulnerable options in a hybrid credit risk model driven by Heston–Nandi GARCH processes

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  • Gechun Liang

    (University of Warwick)

  • Xingchun Wang

    (University of International Business and Economics)

Abstract

This paper proposes a hybrid credit risk model, in closed form, to price vulnerable options with stochastic volatility. The distinctive features of the model are threefold. First, both the underlying and the option issuer’s assets follow the Heston–Nandi GARCH model with their conditional variance being readily estimated and implemented solely on the basis of the observable prices in the market. Second, the model incorporates both idiosyncratic and systematic risks into the asset dynamics of the underlying and the option issuer, as well as the intensity process. Finally, the explicit pricing formula of vulnerable options enables us to undertake the comparative statistics analysis.

Suggested Citation

  • Gechun Liang & Xingchun Wang, 2021. "Pricing vulnerable options in a hybrid credit risk model driven by Heston–Nandi GARCH processes," Review of Derivatives Research, Springer, vol. 24(1), pages 1-30, April.
    • Handle: RePEc:kap:revdev:v:24:y:2021:i:1:d:10.1007_s11147-020-09167-z
    DOI: 10.1007/s11147-020-09167-z
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    Cited by:

    1. Mozumder, Sharif & Frijns, Bart & Talukdar, Bakhtear & Kabir, M. Humayun, 2024. "On practitioners closed-form GARCH option pricing," International Review of Financial Analysis, Elsevier, vol. 94(C).
    2. Geonwoo Kim, 2020. "Valuation of Exchange Option with Credit Risk in a Hybrid Model," Mathematics, MDPI, vol. 8(11), pages 1-11, November.
    3. Panhong Cheng & Zhihong Xu & Zexing Dai, 2023. "Valuation of vulnerable options with stochastic corporate liabilities in a mixed fractional Brownian motion environment," Mathematics and Financial Economics, Springer, volume 17, number 3, December.
    4. Xingchun Wang, 2022. "Valuing fade-in options with default risk in Heston–Nandi GARCH models," Review of Derivatives Research, Springer, vol. 25(1), pages 1-22, April.
    5. Xingchun Wang, 2021. "Pricing vulnerable options with jump risk and liquidity risk," Review of Derivatives Research, Springer, vol. 24(3), pages 243-260, October.
    6. Xie, Yurong & Deng, Guohe, 2022. "Vulnerable European option pricing in a Markov regime-switching Heston model with stochastic interest rate," Chaos, Solitons & Fractals, Elsevier, vol. 156(C).
    7. Wang, Xingchun & Zhang, Han, 2022. "Pricing basket spread options with default risk under Heston–Nandi GARCH models," The North American Journal of Economics and Finance, Elsevier, vol. 59(C).

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    More about this item

    Keywords

    Vulnerable options; Hybrid credit risk model; Heston–Nandi GARCH model; Closed form formula;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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