Pricing of Fixed-Strike Lookback Options on Assets with Default Risk

Abstract

In over-the-counter markets, many options on defaultable instruments are influenced by default risks emanating from the possibility that the option writer may not fulfill its contractual obligations. In this paper, we investigate the valuation of fixed-strike lookback options based on the issuer’s credit risk. Using double Mellin transforms and the method of images, we have a closed-form solution to fixed-strike lookback options with a default risk. Furthermore, we analyze the values of the vulnerable fixed-strike lookback options with respect to the model parameters and also show that the Monte Carlo simulations and the Implicit Finite Difference Method converge to the closed-form solutions and this verifies the correctness of our formulas.