Valuation of vulnerable European options with market liquidity risk

In this paper, we investigate the pricing of vulnerable European options in a market where the underlying stocks are not perfectly liquid. A liquidity discount factor is used to model the effect of liquidity risk in the market, and the default risk of the option issuer is incorporated into the model...

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Bibliographic Details
Published in:Probability in the engineering and informational sciences 2024-01, Vol.38 (1), p.65-81
Main Authors: Pan, Yihao, Tang, Dan, Wang, Xingchun
Format: Article
Language:English
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Summary:In this paper, we investigate the pricing of vulnerable European options in a market where the underlying stocks are not perfectly liquid. A liquidity discount factor is used to model the effect of liquidity risk in the market, and the default risk of the option issuer is incorporated into the model using a reduced-form model, where the default intensity process is correlated with the liquidity risk. We obtain a semiclosed-form pricing formula of vulnerable options through the inverse Fourier transform. Finally, we illustrate the effects of default risk and liquidity risk on option prices numerically.
ISSN:0269-9648
1469-8951
DOI:10.1017/S026996482200050X