Utility-based indifference pricing in regime-switching models |
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| Authors: | Robert J Elliott Tak Kuen Siu |
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| Institution: | a School of Mathematical Sciences, University of Adelaide, SA 5005, Australiab Haskayne School of Business, University of Calgary, Calgary, Alberta, Canadac Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW 2109, Australia |
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| Abstract: | In this paper, we study utility-based indifference pricing and hedging of a contingent claim in a continuous-time, Markov, regime-switching model. The market in this model is incomplete, so there is more than one price kernel. We specify the parametric form of price kernels so that both market risk and economic risk are taken into account. The pricing and hedging problem is formulated as a stochastic optimal control problem and is discussed using the dynamic programming approach. A verification theorem for the Hamilton-Jacobi-Bellman (HJB) solution to the problem is given. An issuer’s price kernel is obtained from a solution of a system of linear programming problems and an optimal hedged portfolio is determined. |
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| Keywords: | Contingent claim valuation Hedging Regime-switching risk Utility indifference Product price kernel Dynamic programming Markov regime-switching Hamilton-Jacobi-Bellman (HJB) equations Exponential utility Linear programming |
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