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Option Valuation Under a Double Regime-Switching Model

Authors

  • Yang Shen,

    1. Yang Shen is a PhD candidate at the Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW, Australia
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  • Kun Fan,

    1. Kun Fan is a joint PhD candidate at the School of Finance and Statistics, East China Normal University, Shanghai, China and the Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW, Australia.
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  • Tak Kuen Siu

    Corresponding author
    1. Tak Kuen Siu is a Professor of Actuarial Science in the Faculty of Actuarial Science and Insurance at the Cass Business School, City University London, London, United Kingdom
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  • We thank the editor and an anonymous referee for their helpful comments. Tak Kuen Siu would like to acknowledge the Discovery Grant from the Australian Research Council (ARC) (project no.: DP1096243).

Abstract

This paper is concerned with option valuation under a double regime-switching model, where both the model parameters and the price level of the risky share depend on a continuous-time, finite-state, observable Markov chain. In this incomplete market set up, we first employ a generalized version of the regime-switching Esscher transform to select an equivalent martingale measure which can incorporate both the diffusion and regime-switching risks. Using an inverse Fourier transform, an analytical option pricing formula is obtained. Finally, we apply the fast Fourier transform method to compute option prices. Numerical examples and empirical studies are used to illustrate the practical implementation of our method. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:451–478, 2014

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