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Review of Quantitative Finance and Accounting

Erschienen in:

01.05.2014 | Original Research

A reduced lattice model for option pricing under regime-switching

verfasst von: Massimo Costabile, Arturo Leccadito, Ivar Massabó, Emilio Russo

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2014

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Abstract

We present a binomial approach for pricing contingent claims when the parameters governing the underlying asset process follow a regime-switching model. In each regime, the asset dynamics is discretized by a Cox–Ross–Rubinstein lattice derived by a simple transformation of the parameters characterizing the highest volatility tree, which allows a simultaneous representation of the asset value in all the regimes. Derivative prices are computed by forming expectations of their payoffs over the lattice branches. Quadratic interpolation is invoked in case of regime changes, and the switching among regimes is captured through a transition probability matrix. An econometric analysis is provided to pick reasonable volatility values for option pricing, for which we show some comparisons with the existing models to assess the goodness of the proposed approach.

Vorheriger Artikel A simple correction of the WACC discount rate for default risk and bankruptcy costs

Nächster Artikel Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?

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This space of equivalent martingale measures is general and flexible enough to incorporate both the diffusion risk and the regime-switching risk.

This is also the method used by Khaliq and Liu (2008) in the numerical comparison of their PDE implicit schemes.

c ₁(n, j) is the European option payoff on the ending nodes for the low-volatility regime. Generally, in a L-regime economy, c _l(n, j), l = 0, …, L − 1, is the European option payoff on the ending nodes for the lth volatility regime.

Data has been downloaded from Datastream.

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2011.

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Titel: A reduced lattice model for option pricing under regime-switching
verfasst von: Massimo Costabile
Arturo Leccadito
Ivar Massabó
Emilio Russo
Publikationsdatum: 01.05.2014
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2014
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-013-0357-9

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