American Options in Regime-Switching Models

Abstract:     
In the paper, we solve the pricing problem for American options in Markov-modulated Levy models. The early exercise boundaries and prices are calculated using a generalization of Carr's randomization for regime-switching models. The pricing procedure is efficient even if the number of states is large provided the transition rates are not large w.r.t. the riskless rates. The payoffs and riskless rates may depend on a state. Special cases are stochastic volatility models and models with stochastic interest rate; both must be modelled as finite-state Markov chains.

Keywords: optimal stopping, American options, finite time horizon, regime switching, Levy processes, stochastic volatility models, stochastic interest rate models

JEL Classifications: D81, C61, G31

Working Paper Series