Perpetual American Options in Regime-Switching Models

Abstract

In the paper, we solve the pricing problem for perpetual American options in Markov-modulated Levy models. The early exercise boundaries and prices are calculated using an iteration procedure. The pricing procedure is efficient even if the number of states is large provided the transition rates are not large w.r.t. the riskless rates. The payoffs and riskless rates may depend on a state. Special cases are stochastic volatility models and models with stochastic interest rate; both must be modelled as finite-state Markov chains.

Keywords: optimal stopping, American options, regime switching, Levy processes, stochastic volatility models, stochastic interest rate models

JEL Classification: D81, C61, G31