Arbitrage pricing of defaultable game options with applications to convertible bonds

Abstract

This paper is the first in a series that we devote to studying the problems of valuation and hedging of defaultable game options in general, and convertible corporate bonds in particular. Here, we present mathematical foundations for our overall study. Specifically, we provide several results characterizing the arbitrage price of a defaultable game option in terms of relevant Dynkin games. In addition, we provide important results regarding price decomposition of defaultable options. These general results are then specified to the case of convertible bonds, yielding in particular a decomposition of convertible bonds in an optional and a bond component.