The Valuation of Options on Bonds with Default Risk

Belhaj, Riadh

Volume 10, Numbers 3 & 4 / September/December , Pages 153-305

Multinational Finance Journal, 2006, vol.10, no.3/4, pp. 277-305

Riadh Belhaj , Conservatoire National des Arts et Métiers, France Corresponding Author

Abstract:
In this paper we present a model for valuing European and American options, which incorporates both default and interest rate risks. We develop a framework that permits evaluation of three kinds of options: (i) options issued by default-free counterparties on risky bonds, (ii) options issued by risky counterparties on default-free bonds and (iii) options issued by risky counterparties on risky bonds — a case where default risk enters at both levels. We show that the price of a put option on a risky discount bond is hump shaped for a European put and monotone increasing for an American put. We also find that the price impact of default risk is less for an American put option than for a European one.

Keywords : option pricing; default risk; defaultable bonds; vulnerable options
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