Option Pricing with Economic Regime Shifts

38 Pages Posted: 3 Apr 2020

See all articles by Tan Wang

Tan Wang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Yonggan Zhao

Dalhousie University - Rowe School of Business

Date Written: February 17, 2020

Abstract

Assuming that one-period logarithmic returns of the underlying asset follow a hidden Markov process, we develop a valuation model for European call options. Unlike existing option pricing models, our pricing mechanism relies on the optimal non exponential-affine stochastic discount factor characterized with economic strength. Monthly S\&P 500 index options for the period, January 2014 to October 2018, are used for model validation. It is found that risk/return profiles under the optimal risk neutral probability measure associated with a non exponential-affine stochastic discount factor are drastically different across the regimes of economic strength. We use both the absolute pricing error and the model-implied volatility criteria to examine model performance. In comparison with alternative models, empirically evidenced unbalanced pricing errors for deeply in-the-money and deeply out-of-the-money options are substantially reduced.

Keywords: Option Pricing; Economic Indicators; Bayesian Information Criterion; Hidden Markov Model; Equivalent Martingale Measure; Risk Neutral Valuation; Implied Volatility

JEL Classification: E3; E37; G12; G13

Suggested Citation

Wang, Tan and Zhao, Yonggan, Option Pricing with Economic Regime Shifts (February 17, 2020). Available at SSRN: https://ssrn.com/abstract=3539526 or http://dx.doi.org/10.2139/ssrn.3539526

Tan Wang (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Yonggan Zhao

Dalhousie University - Rowe School of Business ( email )

6100 University Avenue
Suite 2010
Halifax, Nova Scotia B3H 4R2
Canada
1-902-494-6972 (Phone)
1-902-494-1053 (Fax)

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