A reduced lattice model for option pricing under regime-switching

We present a binomial approach for pricing contingent claims whenthe parameters governing the underlying asset process follow a regime-switchingmodel. In each regime, the asset dynamics is discretized by a Cox-Ross-Rubinsteinlattice derived by a simple transformation of the parameters characterizing thehighest volatility tree, which allows a simultaneous representation of the assetvalue in all the regimes. Derivative prices are computed by forming expecta-tions of their payos over the lattice branches. Quadratic interpolation is in-voked in case of regime changes, and the switching among regimes is capturedthrough a transition probability matrix. An econometric analysis is providedto pick reasonable volatility values for option pricing, for which we show somecomparisons with the existing models to assess the goodness of the proposedapproach.

We present a binomial approach for pricing contingent claims when the parameters governing the underlyingasset process follow a regime-switching model. In each regime, the asset dynamics is discretized by a Cox-Ross-Rubinstein lattice derived by a simple transformation of the parameters characterizing the highest volatility tree,which allows a simultaneous representation of the asset value in all the regimes. Derivative prices are computedby forming expectations of their payoffs over the lattice branches. Quadratic interpolation is invoked in caseof regime changes, and the switching among regimes is captured through a transition probability matrix. Aneconometric analysis is provided to pick reasonable volatility values for option pricing, for which we show somecomparisons with the existing models to assess the goodness of the proposed approach.