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Regime switching stochastic volatility option pricing

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  • Sovan Mitra

Abstract

Stochastic volatility option pricing has become popular in financial mathematics due to its theoretical and empirical consistencies. However, stochastic volatility models generally suffer from analytical and calibration intractability, except for regime switching stochastic volatility. However, regime switching models neither model volatility nor price options over short time periods accurately, hence they are of limited use. This paper proposes a general method of pricing regime switching options over short time periods. We achieve this by relating Fouque's perturbation based option pricing method to regime switching models. We conduct numerical experiments to validate our method using empirical S&P 500 index option prices and compare our results to Black-Scholes and Fouque's standard option pricing method. We demonstrate our pricing method which provides lower relative error compared to the Fouque's standard option pricing method and Black-Scholes pricing. In addition, this paper can be seen as an extension to Fouque's standard option pricing method.

Suggested Citation

  • Sovan Mitra, 2010. "Regime switching stochastic volatility option pricing," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 1(2), pages 213-242.
    • Handle: RePEc:ids:ijfmkd:v:1:y:2010:i:2:p:213-242
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    Cited by:

    1. Mitra, Sovan, 2013. "Operational risk of option hedging," Economic Modelling, Elsevier, vol. 33(C), pages 194-203.
    2. Lin, Lisha & Li, Yaqiong & Wu, Jing, 2018. "The pricing of European options on two underlying assets with delays," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 495(C), pages 143-151.
    3. Marcos Escobar & Daniela Neykova & Rudi Zagst, 2015. "Portfolio Optimization In Affine Models With Markov Switching," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(05), pages 1-46.
    4. M. Escobar & D. Neykova & R. Zagst, 2017. "HARA utility maximization in a Markov-switching bond–stock market," Quantitative Finance, Taylor & Francis Journals, vol. 17(11), pages 1715-1733, November.

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