School of Economics and Finance

No. 426: Option Pricing under Discrete Shifts in Stock Returns

Kyriakos Chourdakis , Queen Mary, University of London
Elias Tzavalis , Queen Mary, University of London

November 1, 2000

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In this paper we introduce a pricing model for a European call option when the price of the underlying stock (asset) follows a random walk with Markov chain type of shifts in the drift and volatility parameters according to the regime that the stock market lies in, at a given period of time. We show that the model can explain the main stylized facts of the option pricing literature and substantially reduce the BS option pricing biases when it allows for time-varying transition probabilities between the regimes of the stock market.

J.E.L classification codes: G10, G13, G22

Keywords:Markov regime switching, Option pricing, Volatility smile