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

Research output: Contribution to journalArticle

24 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 languageEnglish
Pages (from-to)694-713
Number of pages20
JournalJournal of Economic Dynamics and Control
Volume35
Issue number5
DOIs
Publication statusPublished - May 2011

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