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Analytically pricing exchange options with stochastic liquidity and regime switching

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  • Xin‐Jiang He
  • Sha Lin

Abstract

We investigate the valuation of exchange options when the market is affected by changing economic conditions as well as liquidity risks. The volatility and expected returns of both stocks are assumed to be controlled by a continuous‐time Markov chain to reflect the effects of varying economic conditions, and a liquidity discounting factor is employed to capture the impact of market liquidity on stock prices. Once the model has been established, we construct a risk‐neutral measure with the use of regime‐switching Esscher transform, and the characteristic function is then derived in an analytical form, so that a closed‐form formula for exchange options can be presented. We further analyze the effects of the two considered factors on exchange option prices numerically.

Suggested Citation

  • Xin‐Jiang He & Sha Lin, 2023. "Analytically pricing exchange options with stochastic liquidity and regime switching," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(5), pages 662-676, May.
    • Handle: RePEc:wly:jfutmk:v:43:y:2023:i:5:p:662-676
    DOI: 10.1002/fut.22403
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    Cited by:

    1. Sharif Mozumder & Bakhtear Talukdar & M. Humayun Kabir & Bingxin Li, 2024. "Non-linear volatility with normal inverse Gaussian innovations: ad-hoc analytic option pricing," Review of Quantitative Finance and Accounting, Springer, vol. 62(1), pages 97-133, January.
    2. He, Xin-Jiang & Lin, Sha, 2023. "Analytically pricing variance and volatility swaps under a Markov-modulated model with liquidity risks," The North American Journal of Economics and Finance, Elsevier, vol. 67(C).
    3. Xin‐Jiang He & Sha Lin, 2023. "Analytically pricing European options under a hybrid stochastic volatility and interest rate model with a general correlation structure," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(7), pages 951-967, July.

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