COS method for option pricing under a regime-switching model with time-changed Lévy processes

G. Tour, N. Thakoor, A. Q. M. Khaliq and D. Y. Tangman

Quantitative Finance, 2018, vol. 18, issue 4, 673-692

Abstract: We extend the regime-switching model to the rich class of time-changed Lévy processes and use the Fourier cosine expansion (COS) method to price several options under the resulting models. The extension of the COS method to price under the regime-switching model is not straightforward because it requires the evaluation of the characteristic function which is based on a matrix exponentiation which is not an easy task. For a two-state economy, we give an analytical expression for computing this matrix exponential, and for more than two states, we use the Carathéodory–Fejér approximation to find the option prices efficiently. In the new framework developed here, it is possible to allow switches not only in the model parameters as is commonly done in literature, but we can also completely switch among various popular financial models under different regimes without any additional computational cost. Calibration of the different regime-switching models with real market data shows that the best models are the regime-switching time-changed Lévy models. As expected by the error analysis, the COS method converges exponentially and thus outperforms all other numerical methods that have been proposed so far.

Date: 2018
References: Add references at CitEc
Citations: View citations in EconPapers (9)

Downloads: (external link)
http://hdl.handle.net/10.1080/14697688.2017.1412494 (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:taf:quantf:v:18:y:2018:i:4:p:673-692

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RQUF20

DOI: 10.1080/14697688.2017.1412494

Access Statistics for this article

Quantitative Finance is currently edited by Michael Dempster and Jim Gatheral

More articles in Quantitative Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().