Pricing Vulnerable Options with Copulas

Umberto Cherubini and Elisa Luciano

ICER Working Papers - Applied Mathematics Series from ICER - International Centre for Economic Research

Abstract: In this paper we apply a copula function pricing technique to the evaluation of vulnerable options, i.e. options with counterpart risk. Using copulas enables to separate the specification of marginal distributions and the dependence structure of the events of exercise of the option and default of the counterpart. Our proof that counterpart risk is evaluated as a copula function is based on no-arbitrage arguments only. This makes our results directly applicable to incomplete market models. Also, the no-arbitrage arguments provide easy-to-implement super-replication strategies. We study digital, call and put options with counterpart risk. Furtehr, we price a credit derivative contract, namely a default put option. We calibrate the models on real market data, using a mixing copula, which provides closed form pricing formulas.

Pages: 37 pages
Date: 2002-01
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (13)

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