Abstract
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.
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 language | English |
|---|---|
| Pages (from-to) | 369-388 |
| Journal | Acta Mathematicae Applicatae Sinica |
| Volume | 25 |
| Issue number | 3 |
| DOIs | |
| Publication status | Published - 2009 |
| Externally published | Yes |