Pricing fuzzy vulnerable options and risk management

The assumption of unrealistic "identical rationality" in classic option pricing theory is released in this article to amend Klein's [Klein, P. (1996). Pricing Black-Scholes options with correlated credit risk. Journal of Banking Finance, 1211-1129] vulnerable option pricing formula. Through this formula, default risk and liquidity risk are both well-explained when the investment behaviors and market expectations of the participants are heterogeneous. The numerical results show that when the investing decisions of each market participant come from their individual rationality and use their own subjective price to trade, the option price becomes a boundary. The upper boundary becomes an absolutely safe line and the lower boundary becomes an absolutely unsafe line for investors who want to invest in some financial securities with default risk. The proposed model suggests a more realistic pricing mechanism for the issuers and traders who want to value options with default risk. (C) 2009 Elsevier Ltd. All rights reserved.