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Regime-Switching Recombining Tree For Option Pricing

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  • R. H. LIU

    ()
    (Department of Mathematics, University of Dayton, 300 College Park, Dayton, OH 45469-2316, USA)

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    Abstract

    In this paper we develop an efficient tree approach for option pricing when the underlying asset price follows a regime-switching model. The tree grows only linearly as the number of time steps increases. Thus it enables us to use large number of time steps to compute accurate prices for both European and American options. We present conditions that guarantee the positivity of branch probabilities. We numerically test the sensitivity of option prices to the choice of a key parameter for tree construction. As an interesting application, we develop a regime-switching model to approximate the Heston's stochastic volatility model and then employ the tree approach to approximate the option prices. Numerical results are provided and compared.

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    Bibliographic Info

    Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

    Volume (Year): 13 (2010)
    Issue (Month): 03 ()
    Pages: 479-499

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    Handle: RePEc:wsi:ijtafx:v:13:y:2010:i:03:p:479-499

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    Related research

    Keywords: Regime-switching model; recombining tree; option pricing; stochastic volatility;

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    Cited by:
    1. Massimo Costabile & Arturo Leccadito & Ivar Massabó & Emilio Russo, 2014. "A reduced lattice model for option pricing under regime-switching," Review of Quantitative Finance and Accounting, Springer, vol. 42(4), pages 667-690, May.

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