Option pricing when the regime-switching risk is priced |
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Authors: | Tak Kuen Siu Hailiang Yang |
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Institution: | [1]Department of Mathematics and Statistics, Curtin University of Technology, Perth, W.A. 6845, Australia [2]Department of Statistics and Actuarial Science, the University of Hong Kong, Pokfulam Road, Hong Kong |
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Abstract: | We study the pricing of an option when the price dynamic of the underlying risky asset is governed by a Markov-modulated geometric
Brownian motion. We suppose that the drift and volatility of the underlying risky asset are modulated by an observable continuous-time,
finite-state Markov chain. We develop a two-stage pricing model which can price both the diffusion risk and the regime-switching
risk based on the Esscher transform and the minimization of the maximum entropy between an equivalent martingale measure and
the real-world probability measure over different states. Numerical experiments are conducted and their results reveal that
the impact of pricing regime-switching risk on the option prices is significant.
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Keywords: | Option valuation regime-switching risk two-stage pricing procedure Esscher transform martingale restriction min-max entropy problem |
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