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A tale of two regimes: Theory and empirical evidence for a Markov-modulated jump diffusion model of equity returns and derivative pricing implications

Charles Chang, Cheng-Der Fuh and Shih-Kuei Lin

Journal of Banking & Finance, 2013, vol. 37, issue 8, 3204-3217

Abstract: We provide closed-form solutions for a continuous time, Markov-modulated jump diffusion model in a general equilibrium framework for options prices under a variety of jump diffusion specifications. We further demonstrate that the two-state model provides the leptokurtic return features, volatility smile, and volatility clustering observed empirically for the Dow Jones Industrial Average (DJIA) and its component stocks. Using 10years of stock return data, we confirm the existence of jump intensity switching and clustering, illustrate transition probabilities, and verify superior empirical fit over competing Poisson-style models.

Keywords: Markov-modulated; Jump diffusion; Volatility clustering; Jump clustering; Volatility smile; Options pricing (search for similar items in EconPapers)
JEL-codes: C58 D58 G01 G12 (search for similar items in EconPapers)
Date: 2013
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Handle: RePEc:eee:jbfina:v:37:y:2013:i:8:p:3204-3217