Pricing and managing risks of European-style options in a Markovian regime-switching binomial model

Farzad Alavi Fard, Tak Kuen Siu

Research output: Contribution to journalArticlepeer-review

8 Citations (Scopus)

Abstract

We discuss the pricing and risk management problems of standard European-style options in a Markovian regime-switching binomial model. Due to the presence of an additional source of uncertainty described by a Markov chain, the market is incomplete, so the no-arbitrage condition is not sufficient to fix a unique pricing kernel, hence, a unique option price. Using the minimal entropy martingale measure, we determine a pricing kernel. We examine numerically the performance of a simple hedging strategy by investigating the terminal distribution of hedging errors and the associated risk measures such as Value at Risk and Expected Shortfall. The impacts of the frequency of re-balancing the hedging portfolio and the transition probabilities of the modulating Markov chain on the quality of hedging are also discussed.

Original languageEnglish
Pages (from-to)421-438
Number of pages18
JournalAnnals of Finance
Volume9
Issue number3
DOIs
Publication statusPublished - Aug 2013

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