On the Price of Risk of the Underlying Markov Chain in a Regime-Switching Exponential Lévy Model

Abstract

Regime-switching models (RSM) have been recently used in the literature as alternatives to the Black-Scholes model. Several authors favor RSM as being more realistic since, by construction, they model those exogenous macroeconomic cycles against which asset prices evolve. In the context of derivatives pricing, these models lead to incomplete markets and therefore there exist multiple Equivalent Martingale Measures (EMM) yielding different pricing rules. A fair amount of literature (Buffington and Elliott, Int J Theor Appl Finance 40:267–282, 2002; Elliott et al., Ann Finance 1(4):23–432, 2005) focuses on conveniently choosing a family of EMM leading to closed-form formulas for option prices. These studies often make the assumption that the risk associated with the Markov chain is not priced. Recently, Siu and Yang (Acta Math Appl Sin Engl Ser 25(3):339–388, 2009), proposed an EMM kernel that takes into account all risk components of a regime-switching Black-Scholes model. In this paper, we extend the results and observations made in Siu and Yang (Acta Math Appl Sin Engl Ser 25(3):339–388, 2009) in order to include more general Lévy regime-switching models that allow us to assess the influence of jumps on the price of risk. In particular, numerical results are given for Regime-switching Jump-Diffusion and Variance-Gamma models. Also, we carry out a comparative analysis of the resulting option price formulas with existing regime-switching models such as Naik (J Financ 48:1969–1984, 1993) and Boyle and Draviam (Insur Math Econ 40:267–282, 2007).

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Correspondence to Manuel Morales.

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The analysis and conclusions set forth are those of the author and do not necessarily represent those of the Bank CIBC.

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Momeya, R.H., Morales, M. On the Price of Risk of the Underlying Markov Chain in a Regime-Switching Exponential Lévy Model. Methodol Comput Appl Probab 18, 107–135 (2016). https://doi.org/10.1007/s11009-014-9399-2

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Keywords

  • Regime-switching Levy process
  • Incomplete markets
  • Equivalent martingale measure
  • Insurance and finance applications

AMS 2000 Subject Classification

  • 91G60
  • 91G20
  • 60G44
  • 60G51