Option valuation under a double regime-switching model

Yang Shen, Kun Fan, Tak Kuen Siu*

*Corresponding author for this work

Research output: Contribution to journalArticle

19 Citations (Scopus)

Abstract

This paper is concerned with option valuation under a double regime-switching model, where both the model parameters and the price level of the risky share depend on a continuous-time, finite-state, observable Markov chain. In this incomplete market set up, we first employ a generalized version of the regime-switching Esscher transform to select an equivalent martingale measure which can incorporate both the diffusion and regime-switching risks. Using an inverse Fourier transform, an analytical option pricing formula is obtained. Finally, we apply the fast Fourier transform method to compute option prices. Numerical examples and empirical studies are used to illustrate the practical implementation of our method.

Original languageEnglish
Pages (from-to)451-478
Number of pages28
JournalThe Journal of Futures Markets
Volume34
Issue number5
DOIs
Publication statusPublished - 2014

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