Regime-Switching Risk: To Price or Not to Price?

Tak Kuen Siu

International Journal of Stochastic Analysis, 2011, vol. 2011, 1-14

Abstract:

Should the regime-switching risk be priced? This is perhaps one of the important “normative” issues to be addressed in pricing contingent claims under a Markovian, regime-switching, Black-Scholes-Merton model. We address this issue using a minimal relative entropy approach. Firstly, we apply a martingale representation for a double martingale to characterize the canonical space of equivalent martingale measures which may be viewed as the largest space of equivalent martingale measures to incorporate both the diffusion risk and the regime-switching risk. Then we show that an optimal equivalent martingale measure over the canonical space selected by minimizing the relative entropy between an equivalent martingale measure and the real-world probability measure does not price the regime-switching risk. The optimal measure also justifies the use of the Esscher transform for option valuation in the regime-switching market.

Date: 2011
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://downloads.hindawi.com/journals/IJSA/2011/843246.pdf (application/pdf)
http://downloads.hindawi.com/journals/IJSA/2011/843246.xml (text/xml)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:hin:jnijsa:843246

DOI: 10.1155/2011/843246

Access Statistics for this article

More articles in International Journal of Stochastic Analysis from Hindawi
Bibliographic data for series maintained by Mohamed Abdelhakeem ().