Pricing barrier options by a regime switching model

Pål Nicolai Henriksen

Quantitative Finance, 2011, vol. 11, issue 8, 1221-1231

Abstract: This paper introduces a new way of estimating parameters in a Brownian motion regime switching asset model to incorporate volatility clustering. The regime switching model is then applied to pricing of up-and-in barrier call options. We take the probability of crossing the barrier between simulation points into account, and we increase accuracy in simulations by importance sampling. The regime switching model is compared to the Normal Inverse Gaussian model and the traditional Black-Scholes model, and option prices from the regime switching model are compared to the closed form expression of up-and-in barrier calls in a Black-Scholes market.

Keywords: Regime switching; Volatility clustering; Barrier option; Autocovariance; Brownian bridge; Importance sampling (search for similar items in EconPapers)
Date: 2011
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DOI: 10.1080/14697680903567160

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