Regime-switching risk

To price or not to price?

Tak Kuen Siu*

*Corresponding author for this work

Research output: Contribution to journalArticle

15 Citations (Scopus)
6 Downloads (Pure)

Abstract

Should the regime-switching risk be priced? This is perhaps one of the important normative issues to be addressed in pricing contingent claims under a Markovian, regime-switching, Black-Scholes-Merton model. We address this issue using a minimal relative entropy approach. Firstly, we apply a martingale representation for a double martingale to characterize the canonical space of equivalent martingale measures which may be viewed as the largest space of equivalent martingale measures to incorporate both the diffusion risk and the regime-switching risk. Then we show that an optimal equivalent martingale measure over the canonical space selected by minimizing the relative entropy between an equivalent martingale measure and the real-world probability measure does not price the regime-switching risk. The optimal measure also justifies the use of the Esscher transform for option valuation in the regime-switching market.

Original languageEnglish
Article number843246
Pages (from-to)1-14
Number of pages14
JournalInternational Journal of Stochastic Analysis
Volume2011
DOIs
Publication statusPublished - 2011

Bibliographical note

Copyright the Author(s) 2011. Version archived for private and non-commercial use with the permission of the author/s and according to publisher conditions. For further rights please contact the publisher.

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