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In the regime switching extension of Black-Scholes-Merton model of assetprice dynamics, one assumes that the volatility coefficient evolves as a hiddenpure jump process. Under the assumption of Markov regime switching, we haveconsidered the locally risk minimizing price of European vanilla options. Bypretending these prices or their noisy versions as traded prices, we have firstcomputed the implied volatility (IV) of the underlying asset. Then byperforming several numerical experiments we have investigated the dependence ofIV on the time to maturity (TTM) and strike price of the vanilla options. Wehave observed a clear dependence that is at par with the empirically observedstylized facts. Furthermore, we have experimentally validated that IV timeseries, obtained from contracts with moneyness and TTM varying in particularnarrow ranges, can recover the transition instances of the hidden Markov chain.Such regime recovery has also been proved in a theoretical setting. Moreover,the novel scheme for computing option price is shown to be stable.

Regime recovery using implied volatility in Markov modulated market model