On pricing and hedging options in regime-switching models with feedback effect

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2011

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Elliott, R.
Siu, T.
Badescu, A.

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Journal of Economic Dynamics and Control, 2011; 35(5):694-713

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Robert J. Elliott, Tak Kuen Siu, Alexandru Badescu

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We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure. © 2011 Elsevier B.V.

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Copyright © 2011 Elsevier B.V. All rights reserved.

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