The impact of netting and portfolio effects on the price of vulnerable options

This thesis extends the model of Klein and Inglis (2001) by taking into account the effect of a netting agreement, e.g. an ISDA Master Agreement, and the effect of portfolio diversification on the price of vulnerable European options. The model considers options traded mutually between two option writers one of which may default. Based on this model the credit-risk adjusted price of an option is a conditional price with respect to the portfolio of options to which it is added. Using a numerical approximation (Monte-Carlo simulation), netting and portfolio effects are shown to increase the credit-risk adjusted value of a trading position. The paper shows that the price which a counterparty is willing to receive (pay) for selling (buying) an option, is less (more) than the usual price if the option has a credit risk mitigation effect on the existent portfolio.