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Analytical pricing formulae for vulnerable vanilla and barrier options

Author

Listed:
  • Liang-Chih Liu

    (National Taipei University of Technology)

  • Chun-Yuan Chiu

    (National Yang Ming Chiao Tung University)

  • Chuan-Ju Wang

    (Research Center for Information Technology Innovation, Academia Sinica)

  • Tian-Shyr Dai

    (National Yang Ming Chiao Tung University)

  • Hao-Han Chang

    (National Yang Ming Chiao Tung University)

Abstract

This paper proposes analytically vulnerable vanilla option pricing formulae that simultaneously consider the premature default, the correlation between the underlying asset and the issuer’s asset, and other outstanding debts of the issuer. Our pricing formulae can be easily extended to solve the problem of pricing vulnerable barrier options, which has been rarely studied before. We show that previous studies on pricing (non)-vulnerable vanilla options and barrier options are degenerate cases of our formulae. We conduct numerical experiments to analyze the relations among the financial/contract parameters and counterparty risk, and also empirically evaluate vulnerable vanilla warrants on the TAIEX issued by Capital Securities with detailed studies of parameter calibrations to examine the robustness of our approach.

Suggested Citation

  • Liang-Chih Liu & Chun-Yuan Chiu & Chuan-Ju Wang & Tian-Shyr Dai & Hao-Han Chang, 2022. "Analytical pricing formulae for vulnerable vanilla and barrier options," Review of Quantitative Finance and Accounting, Springer, vol. 58(1), pages 137-170, January.
    • Handle: RePEc:kap:rqfnac:v:58:y:2022:i:1:d:10.1007_s11156-021-00990-5
    DOI: 10.1007/s11156-021-00990-5
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    References listed on IDEAS

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    More about this item

    Keywords

    Vulnerable option; Analytical pricing formula; Credit risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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