A Binomial Tree Approach to Pricing Vulnerable Option in a Vague World

Abstract

The aim of this paper is pricing the vulnerable options in a vague world. Due to the vulnerability of financial markets and the economy environment in the real world, investors cannot always have precise information about firm value and default recovery rate in vulnerable option pricing. Therefore, following the framework of Klein in 1996, a fuzzy binomial tree pricing model is derived by modelling the firm value and default recovery rate as fuzzy numbers. The numerical results show that the precise information assumption about the firm value and recovery rate in Klein model may lead to underestimate the credit risk on the values of vulnerable options. This study aims to provide insights for future research on defaultable options pricing under imprecise market information.