A reduced lattice model for option pricing under regime-switching

Massimo Costabile (), Arturo Leccadito (), Ivar Massabó () and Emilio Russo ()

Review of Quantitative Finance and Accounting, 2014, vol. 42, issue 4, 667-690

Abstract: We present a binomial approach for pricing contingent claims when the parameters governing the underlying asset process follow a regime-switching model. In each regime, the asset dynamics is discretized by a Cox–Ross–Rubinstein lattice derived by a simple transformation of the parameters characterizing the highest volatility tree, which allows a simultaneous representation of the asset value in all the regimes. Derivative prices are computed by forming expectations of their payoffs over the lattice branches. Quadratic interpolation is invoked in case of regime changes, and the switching among regimes is captured through a transition probability matrix. An econometric analysis is provided to pick reasonable volatility values for option pricing, for which we show some comparisons with the existing models to assess the goodness of the proposed approach. Copyright Springer Science+Business Media New York 2014

Keywords: Option pricing; Regime-switching; Binomial lattice; Discrete time models; G13; C52 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Downloads: (external link)
http://hdl.handle.net/10.1007/s11156-013-0357-9 (text/html)
Access to full text is restricted to subscribers.

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:kap:rqfnac:v:42:y:2014:i:4:p:667-690

Ordering information: This journal article can be ordered from
http://www.springer.com/finance/journal/11156/PS2

DOI: 10.1007/s11156-013-0357-9

Access Statistics for this article

Review of Quantitative Finance and Accounting is currently edited by Cheng-Few Lee

More articles in Review of Quantitative Finance and Accounting from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().