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Option pricing in a regime-switching model using the fast Fourier transform

R. H. Liu, Qiang Zhang and G. Yin

International Journal of Stochastic Analysis, 2006, vol. 2006, 1-22


This paper is concerned with fast Fourier transform (FFT) approach to option valuation, where the underlying asset price is governed by a regime-switching geometric Brownian motion. An FFT method for the regime-switching model is developed first. Aiming at reducing computational complexity, a near-optimal FFT scheme is proposed when the modulating Markov chain has a large state space. To test the FFT method, a novel semi-Monte Carlo simulation algorithm is developed. This method takes advantage of the observation that the option value for a given sample path of the underlying Markov chain can be calculated using the Black-Scholes formula. Finally, numerical results are reported.

Date: 2006
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DOI: 10.1155/JAMSA/2006/18109

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Handle: RePEc:hin:jnijsa:018109