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A Discrete-Time Approach to Evaluate Path-Dependent Derivatives in a Regime-Switching Risk Model

Author

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  • Emilio Russo

    (Department of Economics, Statistics and Finance, University of Calabria, Ponte Bucci cubo 1C, 87036 Rende (CS), Italy)

Abstract

This paper provides a discrete-time approach for evaluating financial and actuarial products characterized by path-dependent features in a regime-switching risk model. In each regime, a binomial discretization of the asset value is obtained by modifying the parameters used to generate the lattice in the highest-volatility regime, thus allowing a simultaneous asset description in all the regimes. The path-dependent feature is treated by computing representative values of the path-dependent function on a fixed number of effective trajectories reaching each lattice node. The prices of the analyzed products are calculated as the expected values of their payoffs registered over the lattice branches, invoking a quadratic interpolation technique if the regime changes, and capturing the switches among regimes by using a transition probability matrix. Some numerical applications are provided to support the model, which is also useful to accurately capture the market risk concerning path-dependent financial and actuarial instruments.

Suggested Citation

  • Emilio Russo, 2020. "A Discrete-Time Approach to Evaluate Path-Dependent Derivatives in a Regime-Switching Risk Model," Risks, MDPI, vol. 8(1), pages 1-22, January.
    • Handle: RePEc:gam:jrisks:v:8:y:2020:i:1:p:9-:d:314174
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    References listed on IDEAS

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