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Option pricing under regime switching. (English) Zbl 1405.91609

Summary: This paper develops a family of option pricing models when the underlying stock price dynamic is modelled by a regime switching process in which prices remain in one volatility regime for a random amount of time before switching over into a new regime. Our family includes the regime switching models of J. D. Hamilton [Econometrica 57, No. 2, 357–384 (1989; Zbl 0685.62092)], in which volatility influences returns. In addition, our models allow for feedback effects from returns to volatilities. Our family also includes GARCH option models as a special limiting case. Our models are more general than GARCH models in that our variance updating schemes do not only depend on levels of volatility and asset innovations, but also allow for a second factor that is orthogonal to asset innovations. The underlying processes in our family capture the asymmetric response of volatility to good and bad news and thus permit negative (or positive) correlation between returns and volatility. We provide the theory for pricing options under such processes, present an analytical solution for the special case where returns provide no feedback to volatility levels, and develop an efficient algorithm for the computation of American option prices for the general case.

MSC:

91G20 Derivative securities (option pricing, hedging, etc.)
60G40 Stopping times; optimal stopping problems; gambling theory
91G60 Numerical methods (including Monte Carlo methods)
62M10 Time series, auto-correlation, regression, etc. in statistics (GARCH)

Citations:

Zbl 0685.62092
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Full Text: DOI

References:

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