Option Pricing Under Discrete Shifts in Stock Returns

54 Pages Posted: 17 Mar 2001

See all articles by Kyriakos Chourdakis

Kyriakos Chourdakis

FitchSolutions; CCFEA

Elias Tzavalis

University of London - Queen Mary - Department of Economics

Date Written: November 2000

Abstract

In this paper we introduce a pricing model for a European call option when the price of the underlying stock (asset) follows a random walk with Markov Chain type of shifts in the drift and volatility parameters according to the regime that the stock market lies in, at a given period of time. We show that the model can explain the main stylised facts of the option pricing literature and substantially reduce the BS option pricing biases which allows for time-varying transition probabilities between the regimes of the stock market version preferences, based on traded option prices data.

Keywords: Markov regime switching, Option pricing, Volatility smile.

JEL Classification: G10, G13, C22

Suggested Citation

Chourdakis, Kyriakos and Tzavalis, Elias, Option Pricing Under Discrete Shifts in Stock Returns (November 2000). Available at SSRN: https://ssrn.com/abstract=252307 or http://dx.doi.org/10.2139/ssrn.252307

Kyriakos Chourdakis

FitchSolutions ( email )

101 Finsbury Pavement
London
United Kingdom

CCFEA ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

Elias Tzavalis (Contact Author)

University of London - Queen Mary - Department of Economics ( email )

Mile End Road
London, E1 4NS
United Kingdom

HOME PAGE: http//www.qmw.ac.uk/~ugte184/

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