Option pricing when the regime-switching risk is priced

Tak Kuen Siu, Hailiang Yang*

*Corresponding author for this work

Research output: Contribution to journalArticle

15 Citations (Scopus)

Abstract

We study the pricing of an option when the price dynamic of the underlying risky asset is governed by a Markov-modulated geometric Brownian motion. We suppose that the drift and volatility of the underlying risky asset are modulated by an observable continuous-time, finite-state Markov chain. We develop a two-stage pricing model which can price both the diffusion risk and the regime-switching risk based on the Esscher transform and the minimization of the maximum entropy between an equivalent martingale measure and the real-world probability measure over different states. Numerical experiments are conducted and their results reveal that the impact of pricing regime-switching risk on the option prices is significant.

Original languageEnglish
Pages (from-to)369-388
Number of pages20
JournalActa Mathematicae Applicatae Sinica
Volume25
Issue number3
DOIs
Publication statusPublished - Jul 2009
Externally publishedYes

Keywords

  • Esscher transform
  • Martingale restriction
  • Min-max entropy problem
  • Option valuation
  • Regime-switching risk
  • Two-stage pricing procedure

Fingerprint Dive into the research topics of 'Option pricing when the regime-switching risk is priced'. Together they form a unique fingerprint.

  • Cite this