Option Pricing in Regime-Switching Frameworks With the Extended Girsanov Principle

17 Pages Posted: 25 Aug 2019

See all articles by Frédéric Godin

Frédéric Godin

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

Denis-Alexandre Trottier

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

Date Written: August 20, 2019

Abstract

The recent work of Godin et al. (2019) on derivatives pricing under regime-switching frameworks highlights that traditional pricing methods produce path-dependent prices for vanilla options when regimes are latent. Since such a feature is deemed inconvenient, the latter paper provides the construction of several risk-neutral measures circumventing this problem so as to yield path-independent pricing. The current paper aims at complementing the work of Godin et al. (2019) by providing the construction of an additional risk-neutral measure based on the Extended Girsanov Principle (EGP) which also purges the path-dependence effect. The advantage of the EGP approach lies in its implementation simplicity and its clear interpretability in terms of consistency with hedging agents locally minimizing their risk-adjusted discounted squared hedging errors.

Keywords: Hidden Markov Models, Regime-switching, Option pricing, Extended Girsanov Principle, Path-dependence

JEL Classification: G13, G22

Suggested Citation

Godin, Frédéric and Trottier, Denis-Alexandre, Option Pricing in Regime-Switching Frameworks With the Extended Girsanov Principle (August 20, 2019). Available at SSRN: https://ssrn.com/abstract=3440158 or http://dx.doi.org/10.2139/ssrn.3440158

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

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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