On a Markov Chain approximation method for option pricing with regime-switching

Kun Fan*, Yang Shen, Tak Kuen Siu, Rongming Wang

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

Abstract

In this paper, we discuss a Markov chain approximation method to price European options, American options and barrier options in a Markovian regime-switching environment. The model parameters are modulated by a continuous-time, finite-state, observable Markov chain, whose states represent the states of an economy. After selecting an equivalent martingale measure by the regime-switching Esscher transform, we construct a discrete-time, inhomogeneous Markov chain to approximate the dynamics of the logarithmic stock price process. Numerical examples and empirical analysis are used to illustrate the practical implementation of the method.

Original languageEnglish
Pages (from-to)529-541
Number of pages13
JournalJournal of Industrial and Management Optimization
Volume12
Issue number2
DOIs
Publication statusPublished - Apr 2016

Keywords

  • Option pricing
  • Markov chain approximation
  • regime switching

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