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

Farzad Alavi Fard, Tak Kuen (Ken) Siu

Research output: Contribution to journalMeeting abstract

Abstract

Purpose: We price regime switching risk, when pricing contingent claims in discrete time nance. In addition, we analyse the risk of market incompleteness under Markovian regime switching framework. Originality: This is the first paper in the literature that prices regime switching risk, when pricing contingent claims in discrete time finance. Abstract: We discuss the pricing and risk management problems of standard European-style options in a Markovian regime-switching CRR binomial model. The market in the model is incomplete, so the no-arbitrage condition is not enough to x a unique pricing kernel, hence, a unique option price. Using the minimal entropy martingale measure, we determine a pricing kernel and derive the corresponding delta hedging strategy. We examine numerically the performance of the 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 will also be discussed. Design/methodology/approach: Using the minimal entropy martingale measure, we determine a pricing kernel and derive the corresponding delta hedging strategy. We examine numerically the performance of the hedging strategy by investigating the terminal distribution of hedging errors and the associated risk measures such as Value at Risk and Expected Shortfall.
Original languageEnglish
Pages (from-to)34-35
Number of pages2
JournalExpo 2011 Higher Degree Research : book of abstracts
Publication statusPublished - 2011
EventHigher Degree Research Expo (7th : 2011) - Sydney
Duration: 10 Oct 201111 Oct 2011

Keywords

  • binomial tree
  • Markov chain
  • regime switching
  • hedging error
  • Value at Risk
  • expected shortfall
  • non-parametric distribution

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