Pricing Vulnerable Options When Debts Have Performance-Sensitivity Provisions

This study proposes a model to investigate the impact of performance-sensitive debt on the valuation of vulnerable options. Unlike previous studies where debt is a fixed amount upon option maturity, our proposed model assumes that debt obligation depends on the counterparty’s performance during the life of the contract. We show that the total amount of debts paid by option issuers influences the default boundary, and hence the value of vulnerable options issued by the trading counterparty. The issue that the presence of performance-sensitive debt may mitigate agency conflicts and asymmetric information problems is also addressed. Moreover, we propose methods to measure the agency cost and the cost of information asymmetry for our model. We also develop a quasi- closed form analytical solution and demonstrate its accuracy