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On pricing and hedging options in regime-switching models with feedback effect

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  • Elliott, Robert J.
  • Siu, Tak Kuen
  • Badescu, Alexandru

Abstract

We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 35 (2011)
Issue (Month): 5 (May)
Pages: 694-713

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Handle: RePEc:eee:dyncon:v:35:y:2011:i:5:p:694-713

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Web page: http://www.elsevier.com/locate/jedc

Related research

Keywords: Pricing and hedging Regime-switching Feedback effect Product price kernel Local risk-minimization;

References

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  11. Naik, Vasanttilak, 1993. " Option Valuation and Hedging Strategies with Jumps in the Volatility of Asset Returns," Journal of Finance, American Finance Association, vol. 48(5), pages 1969-84, December.
  12. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
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