Option Pricing when the Regime-Switching Risk is Priced

Tak Kuen Siu, Hailiang Yang*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

17 Citations (Scopus)


We study the pricing of an option when the price dynamic of the underlying risky asset is governed
by a Markov-modulated geometric Brownian motion. We suppose that the drift and volatility of the underlying
risky asset are modulated by an observable continuous-time, finite-state Markov chain. We develop a twostage pricing model which can price both the diffusion risk and the regime-switching risk based on the Esscher
transform and the minimization of the maximum entropy between an equivalent martingale measure and the
real-world probability measure over different states. Numerical experiments are conducted and their results
reveal that the impact of pricing regime-switching risk on the option prices is significant.
Original languageEnglish
Pages (from-to)369-388
JournalActa Mathematicae Applicatae Sinica
Issue number3
Publication statusPublished - 2009
Externally publishedYes


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