Valuing vulnerable options with bond collateral

ABSTRACT

This paper investigates vulnerable European options with bond collateral. Working with stochastic interest rate, we evaluate vulnerable options under four cases of collateral according to the length of time to maturity of the government bonds, including cash, short term bonds, medium term bonds, and long term bonds. The impacts of collateral and credit risk on vulnerable option prices are illustrated numerically.

KEYWORDS:

• Vulnerable Option
• collateral
• credit risk

JEL CLASSIFICATION:

• G13
• G12

Acknowledgments

The authors would like to thank the anonymous referees and the editor, David Peel, for their helpful comments and valuable suggestions that led to several important improvements. All errors are our responsibility.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

This work was supported by the the National Natural Science Foundation of China [71701145, 71790594, 11701084, 11671084];University of International Business and Economics [17YQ01]; Tianjin Philosophical and Social Science Foundation [tjyy17-001].