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Abstract
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We price vulnerable options - i.e. options where the counterparty may default. The main reason for having a counterparty risk is the fact that these options are traded over-the-counter (OTC). According to BIS, the OTC equity-linked option gross market value in the first half of 2006 USD 6.8 tln. While previous literature models vulnerable options in complete markets, we notice this is a case of market incompleteness. We streamline earlier results in complete marets and, in order to price in incomplete markets, we employ the technique of good deal bounds as developed by Bjork-Slinko(2005). We model default in a structural framework and obtain close form solutions for the pricing bounds. Also, we extend the results for European calls to other options and homogenously linear payoffs, such as exchange options. The price bounds obtained are much tighter than the no-arbitrage bounds.
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