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Pricing black-scholes options with correlated credit risk and jump risk

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  • Weidong Xu
  • Weijun Xu
  • Weilin Xiao

Abstract

This article follows the framework of Klein (1996) to present an improved method of pricing vulnerable options under jump diffusion assumptions about the underlying stock prices and firm values which are appropriate in many business situations. In contrast to Klein's (1996) model, jumps allow not only for sudden changes in stock prices and firm values, but also for a firm to default instantaneously because of an unexpected drop in its value. Therefore, our model is able to provide sufficient conceptual insights about the economic mechanism of vulnerable option pricing. In particular, an analytical pricing formula for vulnerable European options under jump diffusion model is derived. The numerical results show that a jump occurrence in firm values can increase the likelihood of default and reduce the vulnerable option prices.

Suggested Citation

  • Weidong Xu & Weijun Xu & Weilin Xiao, 2015. "Pricing black-scholes options with correlated credit risk and jump risk," Applied Economics Letters, Taylor & Francis Journals, vol. 22(2), pages 87-93, January.
    • Handle: RePEc:taf:apeclt:v:22:y:2015:i:2:p:87-93
    DOI: 10.1080/13504851.2013.875098
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    Cited by:

    1. Wang, Xingchun, 2019. "Valuation of new-designed contracts for catastrophe risk management," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).

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