Pricing of vulnerable options under hybrid stochastic and local volatility

Abstract In this study, considering the paradoxical stochastic characteristics of over-the-counter markets during a financial crisis, we examine the price of vulnerable options under the constant-elasticity-of-variance-with-stochastic-volatility (SVCEV) model. This model describes the market situation better than the stochastic volatility model as well as the constant-elasticity-of-variance model. We provide the corrected option price derived by asymptotic analysis, which is an approximation to the price of a vulnerable option under the SVCEV model. Furthermore, we numerically verify the accuracy of the price of a vulnerable option (as obtained using the SVCEV model) by comparing the approximate option price with the option price obtained by Monte Carlo simulation.