A Lattice Method for Lookback Options with Regime-Switching Volatility

27 Pages Posted: 15 Dec 2009 Last revised: 15 Jan 2012

See all articles by Ji Hee Yoon

Ji Hee Yoon

University College London - Department of Economics

U. Jin Choi

Korea Advanced Institute of Science and Technology (KAIST)

Byung Hwa Lim

The University of Suwon - Department of Economics and Finance

Bong-Gyu Jang

Pohang University of Science and Technology (POSTECH)

Date Written: May 24, 2011

Abstract

We develop a lattice method for pricing lookback options in a regime-switching market environment. We assume the market is governed by a two-state Markov chain and stock volatility can change whenever the market environment changes. We develop a method which resolves the bias in the binomial method of Babbs (2000), and combine it with the pentanomial method of Bollen (1998). Our method can be used for American-style lookback options as well as European-style lookback options and is a simple but efficient way for pricing them compared with the methods currently available. We also analyze the convergence of the proposed method.

Keywords: lookback option, Markov chain, regime switch, lattice method, binomial tree, stochastic volatility

JEL Classification: C63, G13

Suggested Citation

Yoon, Ji Hee and Choi, U Jin and Lim, Byung Hwa and Jang, Bong-Gyu, A Lattice Method for Lookback Options with Regime-Switching Volatility (May 24, 2011). Available at SSRN: https://ssrn.com/abstract=1523634 or http://dx.doi.org/10.2139/ssrn.1523634

Ji Hee Yoon

University College London - Department of Economics ( email )

Drayton House, 30 Gordon Street
30 Gordon Street
London, WC1H 0AX
United Kingdom

U Jin Choi

Korea Advanced Institute of Science and Technology (KAIST) ( email )

373-1 Kusong-dong
Yuson-gu
Taejon 305-701, 130-722
Korea, Republic of (South Korea)

Byung Hwa Lim

The University of Suwon - Department of Economics and Finance ( email )

17 Wauan-gil
Bongdam-eup
Hwaseong, Gyeonggi-do 445-743
+82-10-5007-4310 (Phone)

HOME PAGE: http://https://sites.google.com/site/byunghwalim/

Bong-Gyu Jang (Contact Author)

Pohang University of Science and Technology (POSTECH) ( email )

77 Cheongam-ro
Pohang
Korea, Republic of (South Korea)

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