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PRICING VULNERABLE EUROPEAN OPTIONS WITH STOCHASTIC CORRELATION

Published online by Cambridge University Press:  12 January 2017

Xingchun Wang
Xingchun Wang*
Affiliation:
School of International Trade and Economics, University of International Business and Economics, Beijing 100029, People's Republic of China E-mails: xchwangnk@aliyun.com; wangx@uibe.edu.cn
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Abstract

In this paper, we present a new pricing model for vulnerable options, with time-varying variances for each asset described by Generalized Autoregressive Conditional Heteroscedasticity processes and correlated with the return of the asset. By connecting the underlying asset and the counterparty's assets through the market factor channel, the proposed model also captures stochastic correlation between the underlying asset return and the return of the counterparty's assets. The correlation depends on the levels of the variances of both assets and the market index as well. In the proposed framework, the closed-form solution for vulnerable options is derived and numerical results are presented to investigate the impact of counterparty default risk.

Keywords

GARCH modelsstochastic correlationstochastic volatilityvulnerable options
Type
Research Article
Information
Probability in the Engineering and Informational Sciences , Volume 32 , Issue 1 , January 2018 , pp. 67 - 95
Copyright
Copyright © Cambridge University Press 2017 

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