PRICING OPTIONS ON VOLATILITY OF VOLATILITY MODEL BASED ON HESTON’S STOCHASTIC VOLATILITY WITH CREDIT RISK

This paper is a research for pricing OTC(over-thecounter) options to entail default risk occurred by an option writer. We drive the closed-form pricing formula to approximate the prices of the so-called vulnerable options introduced by Klein [12] under the Heston stochastic volatility of volatility(vol-of-vol) model proposed in [5]. In the case of OTC options, the price of both the option writer’s asset as well as the underling asset must be considered for pricing the options, unlike in the case of exchange-traded options. In this paper, we derive the partial differential equations(PDEs) whose solution is the price of the vulnerable options and solve the PDEs by asymptotic analysis [4] and the two dimensional Fourier transform method.