A Simple Approach For Pricing Equity Options With Markov Switching State Variables
- Topics:
- Commercial Lending
- Tags:
- Finance,
- Investment,
- Marketing,
- Marketing Research,
- Pricing,
- Pricing Strategy,
- Santa Clara University,
- Volatility
- Source:
- Santa Clara University
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Overview: This paper develops a lattice method for pricing equity options when volatility switches between many states. The approach is an extremely parsimonious one, and we show that it is feasible to compute prices for American type derivatives in polynomial time, i.e. O(kn2k). The model is computationally efficient, and may be easily extended to empirical work, thus permitting practical calibration. As the number of states k increases, the model extends the simple constant volatility model and becomes analogous to the highly popular class of stochastic volatility models, for which no algorithm exists for the pricing of American options. Hence, the algorithm in this paper has wide applicabability.
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Format: PDF | Size: 180KB | Date: Jan 2003 | Pages: 12
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