Open AccessOn a Markov chain approximation method for option pricing with regime switching
Author(s) -
Kun Fan,
Yang Shen,
Tak Kuen Siu,
Rongming Wang
Publication year - 2015
Publication title -
journal of industrial and management optimization
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.325
H-Index - 32
eISSN - 1553-166X
pISSN - 1547-5816
DOI - 10.3934/jimo.2016.12.529
Subject(s) - markov chain , markov chain mixing time , markov process , martingale (probability theory) , balance equation , logarithm , mathematics , valuation of options , mathematical optimization , discrete time and continuous time , computer science , continuous time markov chain , markov property , statistical physics , markov model , econometrics , mathematical analysis , physics , statistics
In this paper, we discuss a Markov chain approximation method to price European options, American options and barrier options in a Markovian regime-switching environment. The model parameters are modulated by a continuous-time, finite-state, observable Markov chain, whose states represent the states of an economy. After selecting an equivalent martingale measure by the regime-switching Esscher transform, we construct a discrete-time, inhomogeneous Markov chain to approximate the dynamics of the logarithmic stock price process. Numerical examples and empirical analysis are used to illustrate the practical implementation of the method.13 page(s