Pricing American Options in Regime-Switching Models: FFT Realization

23 Pages Posted: 1 May 2008 Last revised: 29 Jul 2008

See all articles by Svetlana Boyarchenko

Svetlana Boyarchenko

University of Texas at Austin - Department of Economics

Sergei Levendorskii

Calico Science Consulting

Date Written: July 2008

Abstract

The pricing problem for American options in Markov-modulated Lévy models is solved. The early exercise boundaries and prices are calculated using a generalization of Carr's randomization procedure 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 modeled as finite-state Markov chains. In contrast with the earlier version of the method, an explicit algorithm is formulated for wide classes of Lévy processes, and FFT and iFFT are used.

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

JEL Classification: G12

Suggested Citation

Boyarchenko, Svetlana I. and Levendorskii, Sergei Z., Pricing American Options in Regime-Switching Models: FFT Realization (July 2008). Available at SSRN: https://ssrn.com/abstract=1127562 or http://dx.doi.org/10.2139/ssrn.1127562

Svetlana I. Boyarchenko (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

Sergei Z. Levendorskii

Calico Science Consulting ( email )

Austin, TX
United States

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