Pricing Vulnerable Options with Constant Elasticity of Variance versus Stochastic Elasticity of Variance
Min-Ku Lee (),
PhD Sung-Jin YANG () and
Jeong-Hoon Kim ()
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Min-Ku Lee: Department of Mathematics, Kunsan National University Republic of Korea
Jeong-Hoon Kim: Department of Mathematics, Yonsei University, Seoul, Republic of Korea Republic of Korea
ECONOMIC COMPUTATION AND ECONOMIC CYBERNETICS STUDIES AND RESEARCH, 2017, vol. 51, issue 1, 233-247
In order to handle option writer’s credit risk, a different underlying price model is required beyond the well-known Black-Scholes model. This paper adopts a recently developed model, which characterizes the 2007-2009 global financial crisis in a unique way, to determine the no-arbitrage price of European options vulnerable to writer’s default possibility. The underlying model is based on the randomization of the elasticity of variance parameter capturing the leverage or inverse leverage effect. We obtain an analytic formula explicitly for the stochastic elasticity of variance correction to the Black-Scholes price of vulnerable options and show how the correction effect is compared with the one given by the constant elasticity of variance model. The result can help to design a dynamic investment strategy reducing option writer’s credit risk more effectively.
Keywords: Vulnerable option; Default risk; Stochastic elasticity of variance; Ornstein-Uhlenbeck process; Monte-Carlo simulation. (search for similar items in EconPapers)
JEL-codes: G12 C65 (search for similar items in EconPapers)
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