Pricing vulnerable options with stochastic liquidity risk |
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| Institution: | 1. School of Banking & Finance, University of International Business and Economics, Beijing, China;2. National Academy of Economic Strategy, Chinese Academy of Social Sciences, Beijing, China;3. School of Statistics, University of International Business and Economics, Beijing, China;1. Department of Mathematics, Kunsan National University, Kunsan 54150, Republic of Korea;2. Department of Mathematics, Yonsei University, Seoul 120-749, Republic of Korea |
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| Abstract: | In this paper, we consider vulnerable options with stochastic liquidity risk. We employ liquidity-adjusted pricing models to describe the underlying stock price and option issuer’s assets. In addition, the correlation between these assets is stochastic, depending on the market liquidity measures. In the proposed framework, we derive closed forms of vulnerable European options with stochastic liquidity risk and then use them to illustrate the effects of stochastic liquidity risk on vulnerable option prices. Numerical results show that the effects of liquidity risk on the prices of out-of-the-money options or the options with a short maturity are not negligible. |
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| Keywords: | Vulnerable options Stochastic liquidity risk Counterparty default risk OTC markets |
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