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Option pricing under Markov‐switching GARCH processes

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  • Chao‐Chun Chen
  • Ming‐Yang Hung

Abstract

This study proposes an N ‐state Markov‐switching general autoregressive conditionally heteroskedastic (MS‐GARCH) option model and develops a new lattice algorithm to price derivatives under this framework. The MS‐GARCH option model allows volatility dynamics switching between different GARCH processes with a hidden Markov chain, thus exhibiting high flexibility in capturing the dynamics of financial variables. To measure the pricing performance of the MS‐GARCH lattice algorithm, we investigate the convergence of European option prices produced on the new lattice to their true values as conducted by the simulation. These results are very satisfactory. The empirical evidence also suggests that the MS‐GARCH model performs well in fitting the data in‐sample and one‐week‐ahead out‐of‐sample prediction. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 30:444–464, 2010

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  • Chao‐Chun Chen & Ming‐Yang Hung, 2010. "Option pricing under Markov‐switching GARCH processes," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 30(5), pages 444-464, May.
    • Handle: RePEc:wly:jfutmk:v:30:y:2010:i:5:p:444-464
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    Cited by:

    1. Lu, Xiaoping & Putri, Endah R.M., 2020. "A semi-analytic valuation of American options under a two-state regime-switching economy," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 538(C).
    2. Chen Tong & Peter Reinhard Hansen & Zhuo Huang, 2022. "Option pricing with state‐dependent pricing kernel," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(8), pages 1409-1433, August.
    3. Massimo Guidolin, 2013. "Markov switching models in asset pricing research," Chapters, in: Adrian R. Bell & Chris Brooks & Marcel Prokopczuk (ed.), Handbook of Research Methods and Applications in Empirical Finance, chapter 1, pages 3-44, Edward Elgar Publishing.
    4. Ma, Jingtang & Li, Wenyuan & Han, Xu, 2015. "Stochastic lattice models for valuation of volatility options," Economic Modelling, Elsevier, vol. 47(C), pages 93-104.

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