Switching Levy Models in Continuous Time: Finite Distributions and Option Pricing

University of Essex, Centre for Computational Finance and Economic Agents (CCFEA) Working Paper

39 Pages Posted: 4 Nov 2005 Last revised: 23 May 2008

Date Written: 2005

Abstract

This paper introduces a general regime switching Levy process, and constructs the characteristic function in closed form. Correlations between the underlying Markov chain and the asset returns are also allowed, by imposing asset price jumps whenever a regime change takes place. Based on the characteristic function the conditional densities and vanilla option prices can be rapidly computed using FFT. It is shown that the regime switching model has the potential to capture a wide variety of implied volatility skews. The paper also discusses the pricing of exotic contracts, like barrier, Bermudan and American options, by implementation of a quadrature method. A detailed numerical experiment illustrates the application of the regime switching framework.

Keywords: volatility smile, volatility skew, derivative pricing, exotic derivatives, calibration

Suggested Citation

Chourdakis, Kyriakos, Switching Levy Models in Continuous Time: Finite Distributions and Option Pricing (2005). University of Essex, Centre for Computational Finance and Economic Agents (CCFEA) Working Paper, Available at SSRN: https://ssrn.com/abstract=838924 or http://dx.doi.org/10.2139/ssrn.838924

Kyriakos Chourdakis (Contact Author)

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CCFEA ( email )

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Colchester, Essex CO4 3SQ
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