A reduced lattice model for option pricing under regime-switching

  • Massimo Costabile
  • Arturo Leccadito
  • Ivar Massabó
  • Emilio Russo
Original Research

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 pricing Regime-switching Binomial lattice Discrete time models 

JEL Classification

G13 C52 

Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  • Massimo Costabile
    • 1
  • Arturo Leccadito
    • 1
  • Ivar Massabó
    • 1
  • Emilio Russo
    • 1
  1. 1.Department of Economics, Statistics, and FinanceUniversity of CalabriaRendeItaly

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