American Put Options with Regime-Switching Volatility
35 Pages Posted: 18 Nov 2005
Date Written: November 18, 2005
Abstract
In this paper we study the price of an American option with stochastic volatility. The nature of stochastic volatility in this paper is as follows: volatility can take two values and changes at the jump time of an independent Poisson process. Namely, the volatility of the underlying asset changes between two regimes, say 'high volatility regime' H and 'low volatility regime' L. We derive an analytic formula for the price of a perpetual put and prove that the price of the perpetual put is always higher in the high volatility regime than in the low volatility regime and the exercise boundary is lower in the high volatility regime than in the low volatility regime. We also show by numerical examples that the Richardson interpolation together with the randomization method by Carr (1998) provides a fast algorithm to approximate the price of an American put with finite expiry and compare our numerical results with the previous study by Bollen (1998).
Keywords: American option, American contingent claim, regime switch, stochastic volatility
JEL Classification: C60, G12, G13
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
The Impact of Jumps in Volatility and Returns
By Michael S. Johannes, Bjorn Eraker, ...
-
Implied Volatility Functions: Empirical Tests
By Bernard Dumas, Jeff Fleming, ...
-
Recovering Risk Aversion from Option Prices and Realized Returns
-
Recovering Probabilities and Risk Aversion from Option Prices and Realized Returns
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Gurdip Bakshi, Nikunj Kapadia, ...
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Nikunj Kapadia, Gurdip Bakshi, ...
-
Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices
By Yacine Ait-sahalia and Andrew W. Lo