REGIME-SWITCHING RECOMBINING TREE FOR OPTION PRICING

Abstract

In this paper we develop an efficient tree approach for option pricing when the underlying asset price follows a regime-switching model. The tree grows only linearly as the number of time steps increases. Thus it enables us to use large number of time steps to compute accurate prices for both European and American options. We present conditions that guarantee the positivity of branch probabilities. We numerically test the sensitivity of option prices to the choice of a key parameter for tree construction. As an interesting application, we develop a regime-switching model to approximate the Heston's stochastic volatility model and then employ the tree approach to approximate the option prices. Numerical results are provided and compared.