Are regime-shift sources of risk priced in the market?

Kyriakos Chourdakis, Yiannis Dendramis () and Elias Tzavalis

Journal of Empirical Finance, 2014, vol. 28, issue C, 151-170

Abstract: In this paper we develop a discrete-time pricing model for European options where the log-return of the underlying asset is subject to discontinuous regime shifts in its mean and/or volatility which follow a Markov chain. The model allows for multiple regime shifts whose risk cannot be hedge out and thus must be priced in option market. The paper provides estimates of the price of regime-shift risk coefficients based on a joint estimation procedure of the Markov regime-switching process of the underlying stock and the suggested option pricing model. The results of the paper indicate that bull-to-bear and bear-to-crash regime shifts carry substantial prices of risk. Risk averse investors in the markets price these regime shifts by assigning higher transition (switching) probabilities to them under the risk neutral probability measure than under the physical. Ignoring these sources of risk will lead to substantial option pricing errors. In addition, the paper shows that investors also price reverse regime shifts, like the crash-to-bear and bear-to-bull ones, by assigning smaller transition probabilities under the risk neutral measure than the physical. Finally, the paper evaluates the pricing performance of the model and indicates that it can be successfully employed, in practice, to price European options.

Keywords: European call prices; Stock market regime shifts; Markov regime switching model; Risk neutral transition probabilities; Occupation time (search for similar items in EconPapers)
JEL-codes: G10 G12 G13 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:28:y:2014:i:c:p:151-170

DOI: 10.1016/j.jempfin.2014.06.004

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