Pricing vulnerable options under a Markov-modulated jump-diffusion model with fire sales

Abstract

In this paper, we consider the valuation of vulnerable options under a Markov-modulated jump-diffusion model, where the option writer's asset value is subject to price pressure from other financial institutions due to distressed selling. A change of numeraire technique, proposed by Geman et al. [ 14 ], is employed to obtain a semi-analytical pricing formula for an vulnerable European option in the presence of regime switching effect. The method is numerically implemented using the multinomial approach in Costabile et al. [ 6 ]. We study the impacts of distressed selling and regime switching on the European option prices via numerical experiments.