European Option Pricing under the Structural Time Series and Markov Regime-switching Model

Pao-Peng Hsu 1; Che-Yang Lin 2

doi:10.18282/ff.v7i1.453

Pao-Peng Hsu 1 1 Department of Tourism and Leisure Management and Department of Applied Finance, Yuanpei University of Medical Technology
Che-Yang Lin 2 2 Department and the Graduate Institute of Business Administration, Yuanpei University of Medical Technology

Ariticle ID: 453

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DOI: https://doi.org/10.18282/ff.v7i1.453

Keywords: Structural time series, Markov regime-switching process, HJM, European call option

Abstract

We present closed-form formulas for the valuation of a European call option whose underlying process is assumed to follow structural time series and the Markov regime-switching process through mean reversion described by a harmonic oscillator. In our model, each parameter has related corresponding economic meaning, and this leads to an easy analy-sis of the interplay between the option and business cycles. Forward rates are assumed under the Heath et al. (1992) HJM framework. The call option analytic formulas are obtained when the joint distribution of occupation times is specified and forward rates are restricted in a one-factor HJM model.

Author Biographies

Pao-Peng Hsu 1, 1 Department of Tourism and Leisure Management and Department of Applied Finance, Yuanpei University of Medical Technology

Department of Tourism and Leisure Management and Department of Applied Finance

Che-Yang Lin 2, 2 Department and the Graduate Institute of Business Administration, Yuanpei University of Medical Technology

Department and the Graduate Institute of Business Administration

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