Pricing American Options in Regime-Switching Models: FFT Realization
23 Pages Posted: 1 May 2008 Last revised: 29 Jul 2008
Date Written: July 2008
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
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