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Type: Journal article
Title: Option pricing using a regime switching stochastic discount factor
Author: Elliott, R.
Hamada, A.
Citation: International Journal of Theoretical and Applied Finance, 2014; 17(3):1450020-1-1450020-26
Publisher: World Scientific Publishing
Issue Date: 2014
ISSN: 0219-0249
Statement of
Robert J. Elliott, Ahmed S. Hamada
Abstract: The paper discusses the pricing of derivatives using a stochastic discount factor modeled as a regime switching geometric Brownian motion. The regime switching is driven by a continuous time hidden Markov chain representing changes in the economy. The stochastic discount factor enables to define a risk neutral measure. We model the stock price as discounted future dividends driven by the same continuous time Markov chain. The stochastic discount factor is used to price European style options under the historical probability measure. The introduction of occupation times of the Markov chain and the corresponding conditional characteristic function allows the evaluation of the expected value of European type claims. The option price is given as a semi-analytical form using the Fourier transform.
Keywords: Stochastic discount factor
option pricing
regime switching
continuous time Markov chain
Rights: © World Scientific Publishing Company
DOI: 10.1142/S0219024914500204
Appears in Collections:Aurora harvest 7
Mathematical Sciences publications

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