Abstract Background/Objectives: The main objective of this paper is to present a model that takes bankruptcy of the seller while calculating the risk involved in fixing the premium at which the underlying options are sold. Methods/Statistical Analysis: A mathematical model which is based on probability distribution have been presented in the paper that extends the binary decision tree model to include bankruptcy for assessing the risk in selling underlying option at premium. Findings: A novel method has been presented that extends the binomial tree for taking into account default probability of the seller. The model can be used by the option seller for computing the risks involved in fixing the premium at which the options can be sold. It has been observed that the option prices considering the bankruptcy are higher compared to the option prices without bankruptcy. Pricing Options Considering Bankruptcy of Underlying Issuer J. K. R. Sastry 1 , K. V. N. M. Ramesh 2 and J. V. R. Murthy 2 1 KL University, Vaddeswaram, Guntur District - 522502, Andhra Pradesh, India; drsastry@kluniversity.in 2 Jawaharlal Nehru Technological University, Kakinada - 533503, Andhra Pradesh, India; kvnmramesh1977@gmail.com, mjonnalagedda@gmail.com Keywords: Bankruptcy, Pricing Option, Underlying Issuer 1. Introduction Options transfer the risk of the underlying from the option buyer to the option seller. Options on underly- ing like stock market indices do not sufer from the risk of bankruptcy, as the probability that the index becomes zero is almost negligible. However while trading options on individual irms; the probability of the irm being bankrupt plays a role in pricing the options being traded on the irm’s stock. On bankruptcy of a company, the payof on the put option is equal to the strike price of the option, which is its maximum. Hence, it is important for the option seller to consider this state while pricing options. In 1,2 do not consider the state of bankruptcy while pricing options. In 3 developed a model to price European options under bankruptcy. In 4 A binomial tree has been developed that introduces a new state of underlying becoming zero from each node in the binomial tree. However, it assumes that the probability of being bankrupty follows a Poisson pro- cess and the tree becomes less volatile when the square of volatility approaches default intensity. In the current study, we address the issue of considering the bankruptcy of a irm while pricing options on its stock. We extend the tree construction methodology pro- posed in 5 by introducing a new state where the irms stock can become zero. he maximum probability of being bankrupt is calculated using the Chebyshev inequal- ity 6 and is multiplied with a factor α which lies between [0, 1]. he methodology does not assume any distribution of the bankruptcy process and takes into account the cur- rent underlying price to measure the probability of being bankrupt. Ininite life time constant volatility difusion famously known as GBM has been considered to be built-in Black– Scholes 7 model. In GBM the stock price is expected to follow Brownian motion which geometric. his model does not consider the issue of bankruptcy which is one of the major limitations of the model. he models built for corporate bands consider extensively the issue of bank- ruptcy and credit spread. he models that are related to stock options, credit spread and bankruptcy have evolved over the time almost simultaneously and independently. However in the recent times both aspects are being con- *Author for correspondence Indian Journal of Science and Technology, Vol 9(17), DOI: 10.17485/ijst/2016/v9i17/93044, May 2016 ISSN (Print) : 0974-6846 ISSN (Online) : 0974-5645