Pricing Options Considering Bankruptcy of Underlying Issuer

Background/Objectives: The main objective of this paper is to present a model that takes bankruptcy of the seller while calculating the risk involved in fixing the premium at which the underlying options are sold. Methods/Statistical Analysis: A mathematical model which is based on probability distribution have been presented in the paper that extends the binary decision tree model to include bankruptcy for assessing the risk in selling underlying option at premium. Findings: A novel method has been presented that extends the binomial tree for taking into account default probability of the seller. The model can be used by the option seller for computing the risks involved in fixing the premium at which the options can be sold. It has been observed that the option prices considering the bankruptcy are higher compared to the option prices without bankruptcy.