JTDerp


Total Posts: 38 
Joined: Nov 2013 


"Abstract: In this article, we consider a model of timevarying volatility which generalizes the classical BlackScholes model to include regimeswitching properties. Specifically, the unobservable state variables for stock fluctuations are modeled by a Markov process, and the drift and volatility parameters take different values depending on the state of this hidden Markov process. We provide a closedform formula for the arbitragefree price of the European call option, when the hidden Markov process has a finite number of states. Two simulation methods, the discrete diffusion method and the Markovian tree method, for computing the European call option price are presented for comparison." ( link )
Topicallyspeaking, there's a similar paper titled "Option Pricing In a JumpDiffusion Model With Regime Switching." ( link )
If you've happened to test an option pricing model with 'regime switching' for the volatility estimate, did you see much improvement in capturing smallscale changes versus a stochastic volatility model?
Side note: An old(ish) thread in Pricing & Modeling subforum, 'Markov Chains for Price Modeling' discussed HMMs and Kalman filters used to forecast equity prices, and I found the several comments (plus some code) by jslade useful at the highlevel conceptuals. 
The clouded mind seeks; the emptied mind finds. 


jslade


Total Posts: 1064 
Joined: Feb 2007 


These are interesting papers JTDerp, but please don't cite me as someone dispensing any great secrets.
I am a humble code merchant who provides software to traders and whoever else will pay me. That said, people do use these ideas all over the place. Most people just use Kalman filters, but HMMs have their place.

"Learning, n. The kind of ignorance distinguishing the studious." 

pj


Total Posts: 3317 
Joined: Jun 2004 


> I am a humble code merchant Nice humblebrag 
The older I grow, the more I distrust the familiar doctrine that age brings wisdom
Henry L. Mencken 


sigma


Total Posts: 105 
Joined: Mar 2009 


>> If you've happened to test an option pricing model with 'regime switching' for the volatility estimate, did you see much improvement in capturing smallscale changes versus a stochastic volatility model?
I am not sure if there any use in "an option pricing model" using a regimeswitching model. For me it is mostly about the option value or its relative value to market price. An nstate regime switching model has n volatilities conditional on the regimes. It's a good model for the realworld modeling, but it is not a model for "smallscale changes" 

