Pricing and managing risks of European-style options in a Markovian regime-switching binomial model

Farzad Fard () and Tak Kuen Siu

Annals of Finance, 2013, vol. 9, issue 3, 438 pages

Abstract: We discuss the pricing and risk management problems of standard European-style options in a Markovian regime-switching binomial model. Due to the presence of an additional source of uncertainty described by a Markov chain, the market is incomplete, so the no-arbitrage condition is not sufficient to fix a unique pricing kernel, hence, a unique option price. Using the minimal entropy martingale measure, we determine a pricing kernel. We examine numerically the performance of a simple hedging strategy by investigating the terminal distribution of hedging errors and the associated risk measures such as Value at Risk and Expected Shortfall. The impacts of the frequency of re-balancing the hedging portfolio and the transition probabilities of the modulating Markov chain on the quality of hedging are also discussed. Copyright Springer-Verlag 2013

Keywords: Binomial tree; Regime switching; Minimum entropy martingale measure; G13; D52 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (7)

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DOI: 10.1007/s10436-012-0192-3

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