Option Pricing Under Regime-Switching Models: Novel Approaches Removing Path-Dependence
46 Pages Posted: 18 Aug 2017 Last revised: 21 Jul 2018
Date Written: July 10, 2018
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: Suggested Citation