Option pricing under regime-switching models: Novel approaches removing path-dependence

Frédéric Godin, Van Son Lai and Denis-Alexandre Trottier

Insurance: Mathematics and Economics, 2019, vol. 87, issue C, 130-142

Abstract: A well-known approach for the pricing of options under regime-switching models is to use the regime-switching Esscher transform (also called regime-switching mean-correcting martingale measure) to obtain risk-neutrality. One way to handle regime unobservability consists in using regime probabilities that are filtered under this risk-neutral measure to compute risk-neutral expected payoffs. The current paper shows that this natural approach creates path-dependence issues within option price dynamics. Indeed, since the underlying asset price can be embedded in a Markov process under the physical measure even when regimes are unobservable, such path-dependence behavior of vanilla option prices is puzzling and may entail non-trivial theoretical features (e.g., time non-separable preferences) in a way that is difficult to characterize. This work develops novel and intuitive risk-neutral measures that can incorporate regime risk-aversion in a simple fashion and which do not lead to such path-dependence side effects. Numerical schemes either based on dynamic programming or Monte-Carlo simulations to compute option prices under the novel risk-neutral dynamics are presented.

Keywords: Option pricing; Regime-switching models; Hidden Markov models; Esscher transform; Path-dependence (search for similar items in EconPapers)
JEL-codes: C61 G13 (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Working Paper: Option Pricing Under Regime-Switching Models: Novel Approaches Removing Path-Dependence (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:87:y:2019:i:c:p:130-142

DOI: 10.1016/j.insmatheco.2019.04.006

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