Valuing Vulnerable Basket Options with Stochastic Liquidity Risk in Reduced-form Models

Bohua Wang, Xingchun Wang () and Mengjie Zhao
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Bohua Wang: School of International Trade and Economics, University of International Business and Economics
Xingchun Wang: School of International Trade and Economics, University of International Business and Economics
Mengjie Zhao: School of International Trade and Economics, University of International Business and Economics

Computational Economics, 2025, vol. 66, issue 3, No 22, 2439-2455

Abstract: Abstract In this paper, we investigate the pricing problem of vulnerable basket options with stochastic liquidity risk in reduced-form models. We use a liquidity-adjusted model to describe all the underlying asset prices and adopt an intensity-based model to capture default risk. Additionally, we incorporate the correlation between the underlying assets and default risk through the liquidity risk channel. In the proposed framework, we obtain an explicit approximation of vulnerable basket option prices. Finally, we illustrate the effects of liquidity risk and default risk on (vulnerable) basket option prices after checking the accuracy of the approximations.

Keywords: Vulnerable basket options; Stochastic liquidity risk; Counterparty default risk; OTC markets; G13 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s10614-024-10794-z

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