On pricing and hedging options in regime-switching models with feedback effect

Robert J. Elliott; Tak Kuen Siu; Alexandru Badescu

doi:10.1016/j.jedc.2010.12.014

On pricing and hedging options in regime-switching models with feedback effect

Robert J. Elliott^*, Tak Kuen Siu, Alexandru Badescu

^*Corresponding author for this work

Department of Applied Finance

Research output: Contribution to journal › Article › peer-review

32 Citations (Scopus)

Abstract

We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure.

Original language	English
Pages (from-to)	694-713
Number of pages	20
Journal	Journal of Economic Dynamics and Control
Volume	35
Issue number	5
DOIs	https://doi.org/10.1016/j.jedc.2010.12.014
Publication status	Published - May 2011

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10.1016/j.jedc.2010.12.014

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abstract = "We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure.",

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AB - We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure.

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On pricing and hedging options in regime-switching models with feedback effect

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