Article1998

Valuing Options in Regime-Switching Models

231 citations0/0 files storedThe Journal of Derivatives

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Stochastic processes and financial applications Financial Markets and Investment Strategies Financial Risk and Volatility Modeling

Abstract

This paper presents a lattice-based method for valuing both European and American-style options in regime-switching models. In a numerical example, the Black-Scholes model is shown to generate significant pricing errors when a regime-switching process governs underlying asset returns. In addition, regime-switching option values are shown to generate implied volatility smiles commonly found in empirical studies. These results provide encouraging evidence that the valuation technique is important, and rich enough to capture salient features of traded option prices. Journal of Derivatives 6, 38-49, Fall 1998

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References

1973The Pricing of Options and Corporate Liabilities 1993A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options 1979Option pricing: A simplified approach 1987The Pricing of Options on Assets with Stochastic Volatilities 1994Implied Binomial Trees 1991Stock Price Distributions with Stochastic Volatility: An Analytic Approach 1996Modeling the conditional distribution of interest rates as a regime-switching process 1977Options: A Monte Carlo approach

Cited by

2012Flexible contracts to cope with uncertainty in public–private partnerships 1999Real Options and Product Life Cycles 2014Optimal design of feed-in-tariffs to stimulate renewable energy investments under regulatory uncertainty — A real options analysis 2006Pricing exotic options under regime switching 2006A Regime-Switching Model for European Options 2002Option pricing under regime switching

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