Pricing European basket warrants with default risk under stochastic volatility models

ABSTRACT

In this paper, we consider basket warrants with default risk in a stochastic volatility model, where the correlation between the underlying assets is stochastic. In addition, we take into account default risk of warrant issuers, and use a reduced form model to capture default risk. In the proposed framework, a closed-form approximation is provided and the effect of default risk is investigated numerically.

KEYWORDS:

• Basket warrants
• default risk
• stochastic volatility
• vulnerable options

JEL CLASSIFICATION:

• G13

Acknowledgments

The author would like to thank the anonymous referees and the editor for their helpful comments and valuable suggestions that led to several important improvements. All errors are my own responsibility.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ Basket warrants without default risk have also been investigated in the literature (see, e.g., Caldana et al. (2016) and Wu and Elliott (2017).

² The closed-form approximation relies on numerical techniques dealing with infinite integrals. In a recent paper, Baschetti, Bormetti, and Romagnoli (2020) propose an effective numerical method to compute option prices called as the SINC approach. We refer to Baschetti, Bormetti, and Romagnoli (2020) for more details on this approach and a systematic comparison with other approaches.

Additional information

Funding

The author acknowledges financial support from the National Natural Science Foundation of China (11701084, 11671084).