Pricing vulnerable options in incomplete markets

This paper follows the framework of P. Klein (1996) to price vulnerable options when the market is incomplete. Vulnerable options, which are usually traded in the over-the-counter market, may not only face the risk of default but also the risk of illiquidity. Thus, pricing such options under the assumption of market completeness, as was done by H. Johnson and R. Stulz (1987) and P. Klein (1996), seems to be a mistake. Accordingly, the proposed model uses the methodology proposed by J. H. Cochrane and J. Saa-Requejo (2000) to price vulnerable options under both deterministic and stochastic interest rates in an incomplete market. The model is found to perform well when the interest rate is stochastic. (C) 2005 Wiley Periodicals, Inc.