Pricing vulnerable options when debts have performance- sensitivity provisions

Yu-Hong Liu, I-Ming Jiang and Mao-Wei Hung

International Review of Economics & Finance, 2025, vol. 103, issue C

Abstract: The objective of this article is to build a new model and use it to investigate the influence of the trading counterparty's PSD obligations on the valuation of vulnerable options. In contrast to the models in previous studies where the debt is a fixed amount upon option maturity, our proposed model assumes that the debt obligation depends on the counterparty's performance during the life of contract. We show that the total amount of debts paid by option issuers influences the default boundary and hence the value of vulnerable options issued by the trading counterparty. The issue that the presence of performance-sensitive debt may mitigate agency conflicts and asymmetric information problems are also addressed. Moreover, we propose methods to measure agency cost and information asymmetry cost for our model. We also develop a quasi-closed form analytical solution and demonstrate its accuracy.

Keywords: Performance-Sensitive Debt; Vulnerable options; Pricing; Counterparty risk; Default risk (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:103:y:2025:i:c:s1059056025006471

DOI: 10.1016/j.iref.2025.104484

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