A Simple Novel Approach to Valuing Risky Zero Coupon Bond in a Markov Regime Switching Economy |
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Authors: | Email author" target="_blank">Amogh?DeshpandeEmail author |
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Institution: | (1) Technology Management and Financial Engineering, Polytechnic University, Six MetroTech Center, 11201 Brooklyn, NY, USA |
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Abstract: | We have addressed the problem of pricing risky zero coupon bond in the framework of Longstaff and Schwartz structural type
model by pricing it as a Down-and-Out European Barrier Call option on the company’s asset-debt ratio assuming Markov regime
switching economy. The growth rate and the volatility of the stochastic asset debt ratio is driven by a continuous time Markov
chain which signifies state of the economy. Regime Switching renders market incomplete and selection of a Equivalent martingale
measure (EMM) becomes a subtle issue. We price the zero coupon risky bond utilizing the powerful technique of Risk Minimizing
hedging of the underlying Barrier option under the so called “Risk Minimal” martingale measure via computing the bond default
probability. |
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Keywords: | |
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