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On pricing and hedging options in regime-switching models with feedback effect |
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| Authors: | Robert J Elliott Tak Kuen SiuAlexandru Badescu |
| Institution: | a School of Mathematical Sciences, University of Adelaide, SA 5005, Australia b Haskayne School of Business, University of Calgary, Calgary, Alberta, Canada T2N 1N4 c Department of Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW 2109, Australia d Department of Mathematics and Statistics, University of Calgary, Calgary, Alberta, Canada T2N 1N4 |
| Abstract: | We study the pricing and hedging of European-style derivative securities in a Markov, regime-switching, model with a feedback effect depending on the economic condition. We adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis. A martingale representation for a European-style index option's price is established based on the price kernel. The martingale representation is then used to construct the local risk-minimizing strategy explicitly and to characterize the corresponding pricing measure. |
| Keywords: | Pricing and hedging Regime-switching Feedback effect Product price kernel Local risk-minimization |
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