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A CLOSED-FORM GARCH VALUATION MODEL FOR POWER EXCHANGE OPTIONS WITH COUNTERPARTY RISK

Published online by Cambridge University Press:  24 January 2019

Xingchun Wang ,
Guangli Xu  and
Dan Li
Xingchun Wang
Affiliation:
School of International Trade and Economics, University of International Business and Economics, Beijing100029, China E-mail: xchwangnk@aliyun.com
Guangli Xu
Affiliation:
School of Statistics, University of International Business and Economics, Beijing100029, China E-mail: xuguangli@uibe.edu.cn; linda9556@163.com
Dan Li
Affiliation:
School of Statistics, University of International Business and Economics, Beijing100029, China E-mail: xuguangli@uibe.edu.cn; linda9556@163.com
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Abstract

In this paper, a discrete-time framework is proposed to value power exchange options with counterparty default risk, where counterparty risk is considered in a reduced-form setting and the variance processes of the underlying assets are captured by GARCH processes. In addition, the proposed model allows for the correlation between the intensity of default and the variances of the underlying assets by breaking down the total risk into systematic and idiosyncratic components. By dint of measure-change techniques and characteristic functions, we obtain the closed-form pricing formula for the value of power exchange options with counterparty default risk. Finally, numerical results are presented to show the power exchange option values.

Keywords

default riskGARCHidiosyncratic riskpower exchange optionssystematic riskG13
Type
Research Article
Information
Probability in the Engineering and Informational Sciences , Volume 34 , Issue 2 , April 2020 , pp. 279 - 296
Copyright
Copyright © Cambridge University Press 2019

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