Vulnerable power exchange options with liquidity risk

Priya Mittal and Dharmaraja Selvamuthu

Physica A: Statistical Mechanics and its Applications, 2025, vol. 672, issue C

Abstract: Modeling the impact of liquidity risk and counterparty default risk on power exchange options is a crucial problem in finance. This paper presents a stochastic model that considers these risks for more accurate pricing of power exchange options. Liquidity risk is considered using a liquidity discount factor, whereas counterparty risk is assessed with firm value models. To derive the pricing formula, the proposed model is transformed into a risk-neutral measure, which is then simplified by applying the Fourier transform to the payoff function and then expressed in terms of the characteristic function. This characteristic function is derived by solving a system of differential equations. To verify the accuracy of the derived pricing formula, a comparison with the simulated option prices is provided. Through numerical analysis, the significance of considering market liquidity and its impact on options prices is illustrated. It has been observed that the liquidity risk increases the options premium. Furthermore, the sensitivity of options prices with respect to various parameters is presented.

Keywords: Credit risk; Asset illiquidity; Over-the-counter (OTC) markets; Exotic options; Fourier transform (search for similar items in EconPapers)
Date: 2025
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378437125002985
Full text for ScienceDirect subscribers only. Journal offers the option of making the article available online on Science direct for a fee of $3,000

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:672:y:2025:i:c:s0378437125002985

DOI: 10.1016/j.physa.2025.130646

Access Statistics for this article

Physica A: Statistical Mechanics and its Applications is currently edited by K. A. Dawson, J. O. Indekeu, H.E. Stanley and C. Tsallis

More articles in Physica A: Statistical Mechanics and its Applications from Elsevier
Bibliographic data for series maintained by Catherine Liu ().