PRICING EQUITY DERIVATIVES SUBJECT TO BANKRUPTCY

• Published in: Mathematical finance Vol. 16; no. 2; pp. 255 - 282
• Main Author: Linetsky, Vadim
• Format: Journal Article
• Language: English
• Published: 350 Main Street , Malden , MA 02148 , USA , and 9600 Garsington Road , Oxford OX4 2DQ , UK Blackwell Publishing, Inc 01.04.2006; Wiley Blackwell; Blackwell Publishing Ltd
• Series: Mathematical Finance
• Subjects: Asian options; Bankruptcy; Brownian exponential functionals; Corporate bonds; Corporate debt; Credit; Credit risk; credit spread; Derivatives; Differential equations; Financial economics; Financial models; hazard rate; implied volatility skew; Mathematical economics; Mathematical models; Options on stocks; Risk management; Schrödinger operator with Morse potential; Securities prices; spectral expansions; Statistical analysis; Stochastic models; Stock options; Studies; Volatility
• ISSN: 0960-1627; 1467-9965
• DOI: 10.1111/j.1467-9965.2006.00271.x

We solve in closed form a parsimonious extension of the Black–Scholes–Merton model with bankruptcy where the hazard rate of bankruptcy is a negative power of the stock price. Combining a scale change and a measure change, the model dynamics is reduced to a linear stochastic differential equation whose solution is a diffusion process that plays a central role in the pricing of Asian options. The solution is in the form of a spectral expansion associated with the diffusion infinitesimal generator. The latter is closely related to the Schrödinger operator with Morse potential. Pricing formulas for both corporate bonds and stock options are obtained in closed form. Term credit spreads on corporate bonds and implied volatility skews of stock options are closely linked in this model, with parameters of the hazard rate specification controlling both the shape of the term structure of credit spreads and the slope of the implied volatility skew. Our analytical formulas are easy to implement and should prove useful to researchers and practitioners in corporate debt and equity derivatives markets.