TY - JOUR
T1 - A hidden Markov regime-switching model for option valuation
AU - Liew, Chuin Ching
AU - Siu, Tak Kuen
PY - 2010/12
Y1 - 2010/12
N2 - We investigate two approaches, namely, the Esscher transform and the extended Girsanov's principle, for option valuation in a discrete-time hidden Markov regime-switching Gaussian model. The model's parameters including the interest rate, the appreciation rate and the volatility of a risky asset are governed by a discrete-time, finite-state, hidden Markov chain whose states represent the hidden states of an economy. We give a recursive filter for the hidden Markov chain and estimates of model parameters using a filter-based EM algorithm. We also derive predictors for the hidden Markov chain and some related quantities. These quantities are used to estimate the price of a standard European call option. Numerical examples based on real financial data are provided to illustrate the implementation of the proposed method.
AB - We investigate two approaches, namely, the Esscher transform and the extended Girsanov's principle, for option valuation in a discrete-time hidden Markov regime-switching Gaussian model. The model's parameters including the interest rate, the appreciation rate and the volatility of a risky asset are governed by a discrete-time, finite-state, hidden Markov chain whose states represent the hidden states of an economy. We give a recursive filter for the hidden Markov chain and estimates of model parameters using a filter-based EM algorithm. We also derive predictors for the hidden Markov chain and some related quantities. These quantities are used to estimate the price of a standard European call option. Numerical examples based on real financial data are provided to illustrate the implementation of the proposed method.
UR - http://www.scopus.com/inward/record.url?scp=78049247531&partnerID=8YFLogxK
U2 - 10.1016/j.insmatheco.2010.08.003
DO - 10.1016/j.insmatheco.2010.08.003
M3 - Article
AN - SCOPUS:78049247531
SN - 0167-6687
VL - 47
SP - 374
EP - 384
JO - Insurance: Mathematics and Economics
JF - Insurance: Mathematics and Economics
IS - 3
ER -