Are Regime Shift Risks Priced in Asset Markets?

37 Pages Posted: 29 Jan 2011

See all articles by Kyriakos Chourdakis

Kyriakos Chourdakis

Nomura International Plc

Yiannis Dendramis

University of Cyprus - Department of Accounting and Finance

Elias Tzavalis

Athens University of Economics and Business - Department of Economics

Date Written: February 20, 2010

Abstract

In this paper we introduce a discrete time pricing model for a European call option when the log-return of the underlying stock (asset) is subject to discontinuous market regime type of shifts in its mean or volatility whose risk can be priced in the market. The paper shows how to estimate this model and then it uses it to examine if regime shift sources of risk are priced in option markets. The results of the paper clearly indicate that stock market regime shifts constitute significant sources of risk which are priced in option markets. Ignoring these sources of risks will lead to significant option pricing errors.

Keywords: European call prices, market regime shifts, Markov regime switching model, implied volatility, occupation time, price of risk

JEL Classification: G10, G12, G13

Suggested Citation

Chourdakis, Kyriakos and Dendramis, Yiannis and Tzavalis, Elias, Are Regime Shift Risks Priced in Asset Markets? (February 20, 2010). Available at SSRN: https://ssrn.com/abstract=1750382 or http://dx.doi.org/10.2139/ssrn.1750382

Kyriakos Chourdakis

Nomura International Plc ( email )

1 Angel Lane
London, EC4R 3AB
United Kingdom

Yiannis Dendramis

University of Cyprus - Department of Accounting and Finance ( email )

75 Kallipoleos Street
Nicosia CY 1678, Nicosia P.O. Box 2
Cyprus

Elias Tzavalis (Contact Author)

Athens University of Economics and Business - Department of Economics ( email )

76 Patission Street
GR-10434 Athens
Greece

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