Valuation of European Options Subject to Financial Distress and Interest Rate risk

Abstract

Like the previous article, Klein and Inglis focus on credit risk. But in this case, it is the credit worthiness of the writer of a derivative instrument whose solvency is at issue. The risk of default on a vulnerable contract depends on the (correlated) changes in the value of the underlying for the derivative instrument, the value of the assets of the firm that writes the contract, and the risk-free interest rate. This article derives closed-form valuation equations for vulnerable European calls and puts and presents a number of numerical examples to illustrate the impact of the different model parameters on option value relative to Black-Scholes.