A Lattice Method for Lookback Options with Regime-Switching Volatility
27 Pages Posted: 15 Dec 2009 Last revised: 15 Jan 2012
Date Written: May 24, 2011
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
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