Study on the Binary Option Pricing Formula with Regime-Switching^[1]

Ping Tian Hang Zhou^[2]

Abstract: The mutual conversion between different market conditions, in reality, related to the stability of the market and asset price stability, is a real problem. The problem also attracts a lot of attention among the industry and scholars. Using the hidden Markov model can represent this market phenomenon, and derive the stock option pricing formula. Further, compared with examples of the option pricing results under the two binomial tree models, it is found although the regime-switching models set and the calculation is more complicated, more in line with the objective reality, the option pricing results are useful for understanding issues of financial asset pricing and risk management.

Keywords: Regime-Switching; Hidden Markov Model; Binominal Tree Model; Option Pricing