A Regime-Switching Model for European Options

David D. Yao (), Qing Zhang () and Xun Yu Zhou ()
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David D. Yao: Columbia University
Qing Zhang: University of Georgia
Xun Yu Zhou: The Chinese University of Hong Kong

Chapter Chapter 14 in Stochastic Processes, Optimization, and Control Theory: Applications in Financial Engineering, Queueing Networks, and Manufacturing Systems, 2006, pp 281-300 from Springer

Abstract: Abstract We study the pricing of European-style options, with the rate of return and the volatility of the underlying asset depending on the market mode or regime that switches among a finite number of states. This regime-switching model is formulated as a geometric Brownian motion modulated by a finite-state Markov chain. With a Girsanov-like change of measure, we derive the option price using risk-neutral valuation. We also develop a numerical approach to compute the pricing formula, using a successive approximation scheme with a geometric rate of convergence. Using numerical examples of simple, two- or three-state Markov chain models, we are able to demonstrate the presence of the volatility smile and volatility term structure.

Keywords: Regime switching; option pricing; successive approximations; volatility smile and term structure (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (33)

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Persistent link: https://EconPapers.repec.org/RePEc:spr:isochp:978-0-387-33815-6_14

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DOI: 10.1007/0-387-33815-2_14

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