Pricing Vulnerable Black-Scholes Options With Dynamic Default Barriers

The quot;structural approachquot; to modeling credit risk specifies a stochastic process that the net asset value of the issuing firm is assumed to follow. If firm value falls below a certain quot;default barrier,quot; bankruptcy is triggered and the firm is assumed to default on its vulnerable obligations. In this article, Hui, Lo, and Lee apply the methodology to price vulnerable options written by a default risky firm. They show how a variety of default scenarios may be accommodated by use of a dynamic default barrier, while maintaining a closed-form valuation equation