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A Moment Approach to Pricing Exotic Options Under Regime-Switching

Jonathan Li (jli***at***mie.utoronto.ca)
Roy Kwon (rkwonn***at***mie.utoronto.ca)

Abstract: The switching of market regimes has a significant impact on derivatives pricing that exposes investors to an additional level of risk. However, deriving the exact price of exotic options under regime-switching is still at the early stages of development. In this paper, we consider deriving tight upper and lower bounds for the price of a wide class of exotic options under regime switching. We show that the additional complexity introduced by the regime switching dynamics can be greatly reduced by exploiting the additive structure of the infinitesimal generator of the regime-switching process. As a result, the problem of bounding the option price under regime switching can be reformulated as semidefinite programming (SDP) problem, which can be solved efficiently in practice. The effectiveness of our approach is illustrated through numerical examples.

Keywords: option pricing, semidefinite programming

Category 1: Applications -- OR and Management Sciences (Finance and Economics )

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Entry Submitted: 07/26/2011
Entry Accepted: 07/27/2011
Entry Last Modified: 01/25/2015

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