A hidden Markov-modulated jump diffusion model for European option pricing

Tak Kuen Siu*

*Corresponding author for this work

Research output: Chapter in Book/Report/Conference proceedingChapterpeer-review

8 Citations (Scopus)

Abstract

The valuation of a European-style contingent claim is discussed in a hidden Markov regime-switching jump-diffusion market, where the evolution of a hidden economic state process over time is described by a continuous-time, finite-state, hidden Markov chain. A two-stage procedure is used to discuss the option valuation problem. Firstly filtering theory is employed to transform the original market with hidden quantities into a filtered market with complete observations. Then a generalized version of the Esscher transform based on a Dolé-Dade stochastic exponential is employed to select a pricing kernel in the filtered market. A partialdifferential- integral equation for the price of a European-style option is presented.

Original languageEnglish
Title of host publicationHidden Markov Models in Finance
Subtitle of host publicationFurther Developments and Applications, Volume II
EditorsRogemar S.  Mamon, Robert J.  Elliott
Place of PublicationHeidelberg
PublisherSpringer, Springer Nature
Pages185-209
Number of pages25
Volume209
ISBN (Electronic)9781489974426
ISBN (Print)9781489974419
DOIs
Publication statusPublished - 2014

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