Review of Quantitative Finance and Accounting

, Volume 42, Issue 4, pp 667–690

A reduced lattice model for option pricing under regime-switching

Authors

    • Department of Economics, Statistics, and FinanceUniversity of Calabria
  • Arturo Leccadito
    • Department of Economics, Statistics, and FinanceUniversity of Calabria
  • Ivar Massabó
    • Department of Economics, Statistics, and FinanceUniversity of Calabria
  • Emilio Russo
    • Department of Economics, Statistics, and FinanceUniversity of Calabria
Original Research

DOI: 10.1007/s11156-013-0357-9

Cite this article as:
Costabile, M., Leccadito, A., Massabó, I. et al. Rev Quant Finan Acc (2014) 42: 667. doi:10.1007/s11156-013-0357-9

Abstract

We present a binomial approach for pricing contingent claims when the parameters governing the underlying asset process follow a regime-switching model. In each regime, the asset dynamics is discretized by a Cox–Ross–Rubinstein lattice derived by a simple transformation of the parameters characterizing the highest volatility tree, which allows a simultaneous representation of the asset value in all the regimes. Derivative prices are computed by forming expectations of their payoffs over the lattice branches. Quadratic interpolation is invoked in case of regime changes, and the switching among regimes is captured through a transition probability matrix. An econometric analysis is provided to pick reasonable volatility values for option pricing, for which we show some comparisons with the existing models to assess the goodness of the proposed approach.

Keywords

Option pricingRegime-switchingBinomial latticeDiscrete time models

JEL Classification

G13C52

Copyright information

© Springer Science+Business Media New York 2013