Analytical pricing formulae for vulnerable vanilla and barrier options

Liang-Chih Liu (), Chun-Yuan Chiu (), Chuan-Ju Wang (), Tian-Shyr Dai () and Hao-Han Chang ()
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Liang-Chih Liu: National Taipei University of Technology
Chun-Yuan Chiu: National Yang Ming Chiao Tung University
Chuan-Ju Wang: Research Center for Information Technology Innovation, Academia Sinica
Tian-Shyr Dai: National Yang Ming Chiao Tung University
Hao-Han Chang: National Yang Ming Chiao Tung University

Review of Quantitative Finance and Accounting, 2022, vol. 58, issue 1, No 5, 137-170

Abstract: Abstract This paper proposes analytically vulnerable vanilla option pricing formulae that simultaneously consider the premature default, the correlation between the underlying asset and the issuer’s asset, and other outstanding debts of the issuer. Our pricing formulae can be easily extended to solve the problem of pricing vulnerable barrier options, which has been rarely studied before. We show that previous studies on pricing (non)-vulnerable vanilla options and barrier options are degenerate cases of our formulae. We conduct numerical experiments to analyze the relations among the financial/contract parameters and counterparty risk, and also empirically evaluate vulnerable vanilla warrants on the TAIEX issued by Capital Securities with detailed studies of parameter calibrations to examine the robustness of our approach.

Keywords: Vulnerable option; Analytical pricing formula; Credit risk (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s11156-021-00990-5

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