Pricing vulnerable power exchange options in an intensity based framework

Abstract

In this article, we study the valuation of a European vulnerable power exchange option in an intensity based framework. We assume that the default by the counter-party is the time of the first jump of a doubly stochastic Poisson process whose intensity is modeled by a jump–diffusion process. The dynamics of the two assets are assumed to be driven by correlated jump–diffusion processes. All the three processes are assumed to be correlated in continuous part as well as in the jump part. In the proposed framework, employing the measure-change technique, we obtain the explicit formula for the price of the power exchange option with counter-party risk. Furthermore, sensitivity analysis is given to illustrate the effects of counterparty risk on the price of the option and effect of various parameters on the option prices.