Option Pricing Under Regime-Switching Models: Novel Approaches Removing Path-Dependence

46 Pages Posted: 18 Aug 2017 Last revised: 21 Jul 2018

See all articles by Frédéric Godin

Frédéric Godin

Concordia University, Quebec - Department of Mathematics & Statistics; Université Laval

Van Son Lai

Université Laval

Denis-Alexandre Trottier

Laval University, Faculté d'Administration, Département de Finance et Assurance, Students

Date Written: July 10, 2018

Abstract

Although option pricing schemes in regime-switching frameworks were extensively explored in the literature, many models developed disregard the unobservability of regimes. In such a context, the traditional pricing approach pioneered by Hardy (2001) applied to vanilla options exhibits path-dependence even if the underlying asset price process can be embedded in a Markov process. This property is deemed counterintuitive and puzzling, warranting explanations and alternatives. The current work develops novel risk-neutral measures which remove the path-dependence issue. Pricing approaches based on dynamic programming and Monte-Carlo simulations which rely on the latter measures are illustrated.

Keywords: Option pricing, Regime-switching, Hidden Markov Models, Esscher transform, Path-dependence

JEL Classification: C61, G13

Suggested Citation

Godin, Frédéric and Lai, Van Son and Trottier, Denis-Alexandre, Option Pricing Under Regime-Switching Models: Novel Approaches Removing Path-Dependence (July 10, 2018). Available at SSRN: https://ssrn.com/abstract=3019482 or http://dx.doi.org/10.2139/ssrn.3019482

Frédéric Godin (Contact Author)

Concordia University, Quebec - Department of Mathematics & Statistics ( email )

1455 De Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

Université Laval ( email )

2214 Pavillon J-A. DeSeve
Quebec, Quebec G1K 7P4
Canada

Van Son Lai

Université Laval ( email )

FSA ULaval
Quebec G1V 0A6
Canada
418-656-2131, x3943 (Phone)

Denis-Alexandre Trottier

Laval University, Faculté d'Administration, Département de Finance et Assurance, Students ( email )

Pavillon Palasis-Prince
Quebec, Quebec G1K 7P4
Canada

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