Vulnerable Derivatives and Good Deal Bounds: A Structural Model

Agatha Murgoci

Publikation: Bidrag til tidsskriftTidsskriftartikelForskningpeer review

68 Downloads (Pure)

Abstrakt

We price vulnerable derivatives – i.e. derivatives where the counterparty may default. These are basically the derivatives traded on the over-the-counter (OTC) markets. Default is modelled in a structural framework. The technique employed for pricing is good deal bounds (GDBs). The method imposes a new restriction in the arbitrage free model by setting upper bounds on the Sharpe ratios (SRs) of the assets. The potential prices that are eliminated represent unreasonably good deals. The constraint on the SR translates into a constraint on the stochastic discount factor. Thus, tight pricing bounds can be obtained. We provide a link between the objective probability measure and the range of potential risk-neutral measures, which has an intuitive economic meaning. We also provide tight pricing bounds for European calls and show how to extend the call formula to pricing other financial products in a consistent way. Finally, we numerically analyse the behaviour of the good deal pricing bounds.
OriginalsprogEngelsk
TidsskriftApplied Mathematical Finance
Vol/bind20
Udgave nummer3
Sider (fra-til)246-263
ISSN1350-486X
DOI
StatusUdgivet - jul. 2013

Emneord

  • Good deal bounds
  • Incomplete markets
  • Vulnerable options

Citationsformater