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Option Pricing with Threshold Mean Reversion

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  • Zeyu Chi
  • Fangyuan Dong
  • Hoi Ying Wong

Abstract

Mean reversion and regime switching are well‐known features of commodity prices. Recent empirical research additionally documents the time variation of the mean reversion rate and volatility. This paper considers the option pricing framework for an underlying commodity price with mean reversion rate and volatility change according to a self‐exciting regime switching model. We offer empirical evidence for the proposed model and derive analytic pricing formulas for the European and barrier options. Numerical examples demonstrate the application and the ability of the proposed model in capturing volatility smile and regime‐switching in the mean reversion rate, simultaneously. © 2016 Wiley Periodicals, Inc. Jrl Fut Mark 37:107–131, 2017

Suggested Citation

  • Zeyu Chi & Fangyuan Dong & Hoi Ying Wong, 2017. "Option Pricing with Threshold Mean Reversion," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 37(2), pages 107-131, February.
    • Handle: RePEc:wly:jfutmk:v:37:y:2017:i:2:p:107-131
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    Cited by:

    1. Paolo Pigato, 2019. "Extreme at-the-money skew in a local volatility model," Finance and Stochastics, Springer, vol. 23(4), pages 827-859, October.

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