Vulnerable options with regime switching and stochastic liquidity

Xin-Jiang He, Puneet Pasricha, Tuantuan Lu and Sha Lin

The Quarterly Review of Economics and Finance, 2024, vol. 98, issue C

Abstract: Investigating default risk in pricing options holds significant practical importance, as nearly all market participants and institutions face credit risk. Additionally, economic cycles and asset liquidity are crucial factors that should be incorporated. This paper considers these factors and derives an analytical pricing formula. Specifically, we model the economic cycles through switching volatility driven by a continuous-time Markov chain, while we adopt a discounting factor based on market liquidity levels to model the asset liquidity. We establish a risk-neutral measure after embracing a regime-switching Esscher transform, and formulate a price representation to value vulnerable options analytically despite the complexity of the developed model. We conduct several numerical experiments to validate the model’s efficacy and flexibility.

Keywords: Vulnerable options; Counterparty risks; Regime switching; Liquidity risks; Analytical solution (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:quaeco:v:98:y:2024:i:c:s1062976924001364

DOI: 10.1016/j.qref.2024.101930

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