A Direct Solution Method for Pricing Options in Regime-Switching Models

28 Pages Posted: 12 Jan 2018 Last revised: 21 Sep 2018

See all articles by Masahiko Egami

Masahiko Egami

Kyoto University

Rusudan Kevkhishvili

Graduate School of Economics, Kyoto University

Date Written: September 7, 2018

Abstract

Pricing financial or real options with arbitrary payoffs in regime-switching models is an important problem in finance. Mathematically, it is to solve, under certain standard assumptions, a general form of optimal stopping problems in regime-switching models. In this article, we reduce an optimal stopping problem with an arbitrary value function in a two-regime environment to a pair of optimal stopping problems without regime switching. We then propose a method for finding optimal stopping rules using the techniques available for non-switching problems. In contrast to other methods, our systematic solution procedure is more direct since we first obtain the explicit form of the value functions. In the end, we discuss an option pricing problem which may not be dealt with by the conventional methods, demonstrating the simplicity of our approach.

Keywords: Optimal stopping, Markov switching, Diffusion, Concavity, Perpetual Options

JEL Classification: C610, C630, G130, G300

Suggested Citation

Egami, Masahiko and Kevkhishvili, Rusudan, A Direct Solution Method for Pricing Options in Regime-Switching Models (September 7, 2018). Available at SSRN: https://ssrn.com/abstract=3100673 or http://dx.doi.org/10.2139/ssrn.3100673

Masahiko Egami

Kyoto University ( email )

Yoshida-Honmachi
Sakyo-ku
Kyoto, 606-8501
Japan

Rusudan Kevkhishvili (Contact Author)

Graduate School of Economics, Kyoto University ( email )

Yoshida-Honmachi
Sakyo-ku
Kyoto, 606-8501
Japan

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