A hidden Markov regime-switching model for option valuation

Chuin Ching Liew and Tak Kuen Siu

Insurance: Mathematics and Economics, 2010, vol. 47, issue 3, 374-384

Abstract: We investigate two approaches, namely, the Esscher transform and the extended Girsanov's principle, for option valuation in a discrete-time hidden Markov regime-switching Gaussian model. The model's parameters including the interest rate, the appreciation rate and the volatility of a risky asset are governed by a discrete-time, finite-state, hidden Markov chain whose states represent the hidden states of an economy. We give a recursive filter for the hidden Markov chain and estimates of model parameters using a filter-based EM algorithm. We also derive predictors for the hidden Markov chain and some related quantities. These quantities are used to estimate the price of a standard European call option. Numerical examples based on real financial data are provided to illustrate the implementation of the proposed method.

Keywords: Option; pricing; Regime-switching; Hidden; Markov; model; Esscher; transform; Extended; Girsanov; principle; Filters; and; predictors (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (13)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:47:y:2010:i:3:p:374-384

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