Option valuation and hedging in markets with a crunch

Abstract

Purpose

Option pricing is an integral part of modern financial risk management. The well-known Black and Scholes (1973) formula is commonly used for this purpose. The purpose of this paper is to extend their work to a situation in which the unconditional volatility of the original asset is increasing during a certain period of time.

Design/methodology/approach

The authors consider a market suffering from a financial crisis. The authors provide the solution for the equation of the underlying asset price as well as finding the hedging strategy. In addition, a closed formula of the pricing problem is proved for a particular case. Furthermore, the underlying price sensitivities are derived.

Findings

The suggested formulas are expected to make the valuation of options and the underlying hedging strategies during a financial crisis more precise. A numerical application is provided for determining the premium for a call and a put European option along with the underlying price sensitivities for each option.

Originality/value

An alternative option pricing model is introduced that performs better than existing ones, especially during a financial crisis.

Citation

El-Khatib, Y. and Hatemi-J, A. (2017), "Option valuation and hedging in markets with a crunch", Journal of Economic Studies, Vol. 44 No. 5, pp. 801-815. https://doi.org/10.1108/JES-04-2016-0083