Assessing the Costs of Protection in a Context of Switching Stochastic Regimes

Pauline Barrieu, Nadine Bellamy and Jean-Michel Sahut

Applied Mathematical Finance, 2012, vol. 19, issue 6, 495-511

Abstract: We consider the problem of cost assessment in the context of switching stochastic regimes. The dynamics of a given asset include a background noise, described by a Brownian motion and a random shock, the impact of which is characterized by changes in the coefficient diffusions. A particular economic agent that is directly exposed to variations in the underlying asset price, incurs some costs, , when the underlying asset price reaches a certain threshold, L. Ideally, the agent would make advance provision, or hedge, for these costs at time 0. We evaluate the amount of provision, or the hedging premium, , for these costs in the disrupted environment, with changes in the regime for a given time horizon, and analyse the sensitivity of this amount to possible model misspecifications.

Date: 2012
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DOI: 10.1080/1350486X.2011.642615

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