A hidden Markov regime-switching model for option valuation
AbstractWe investigate two approaches, namely, the Esscher transform and the extended Girsanov's principle, for option valuation in a discrete-time hidden Markov regime-switching Gaussian model. The model's parameters including the interest rate, the appreciation rate and the volatility of a risky asset are governed by a discrete-time, finite-state, hidden Markov chain whose states represent the hidden states of an economy. We give a recursive filter for the hidden Markov chain and estimates of model parameters using a filter-based EM algorithm. We also derive predictors for the hidden Markov chain and some related quantities. These quantities are used to estimate the price of a standard European call option. Numerical examples based on real financial data are provided to illustrate the implementation of the proposed method.
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Bibliographic InfoArticle provided by Elsevier in its journal Insurance: Mathematics and Economics.
Volume (Year): 47 (2010)
Issue (Month): 3 (December)
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Web page: http://www.elsevier.com/locate/inca/505554
Option pricing Regime-switching Hidden Markov model Esscher transform Extended Girsanov principle Filters and predictors;
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