Option Pricing under Discrete Shifts in Stock Returns
AbstractIn this paper we introduce a pricing model for a European call option when the price of the underlying stock (asset) follows a random walk with Markov chain type of shifts in the drift and volatility parameters according to the regime that the stock market lies in, at a given period of time. We show that the model can explain the main stylized facts of the option pricing literature and substantially reduce the BS option pricing biases when it allows for time-varying transition probabilities between the regimes of the stock market.
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Bibliographic InfoPaper provided by Queen Mary, University of London, School of Economics and Finance in its series Working Papers with number 426.
Date of creation: Nov 2000
Date of revision:
Markov regime switching; Option pricing; Volatility smile;
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2001-01-21 (All new papers)
- NEP-FIN-2001-02-21 (Finance)
- NEP-FMK-2000-12-19 (Financial Markets)
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