Accounting for regime and parameter uncertainty in regime-switching models

Brian M. Hartman and Matthew J. Heaton

Insurance: Mathematics and Economics, 2011, vol. 49, issue 3, 429-437

Abstract: As investment guarantees become increasingly complex, realistic simulation of the price becomes more critical. Currently, regime-switching models are commonly used to simulate asset returns. Under a regime switching model, simulating random asset streams involves three steps: (i) estimate the model parameters given the number of regimes using maximum likelihood, (ii) choose the number of regimes using a model selection criteria, and (iii) simulate the streams using the optimal number of regimes and parameter values. This method, however, does not properly incorporate regime or parameter uncertainty into the generated asset streams and therefore into the price of the guarantee. To remedy this, this article adopts a Bayesian approach to properly account for those two sources of uncertainty and improve pricing.

Keywords: Asset price simulation; Bayesian modeling; Dirichlet process (search for similar items in EconPapers)
JEL-codes: C11 G17 (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:49:y:2011:i:3:p:429-437

DOI: 10.1016/j.insmatheco.2011.07.003

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