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An Option Pricing Model with Regime-Switching Economic Indicators

Although the Black-Scholes (BS) model and its alternatives have been widely applied
in finance, their flaws have drawn the attention of many investors and risk managers.
The Black-Scholes (BS) model fails to explain the volatility smile. Its alternatives,
such as the BS model with a Poisson jump process, fail to explain the volatility
clustering. Based on the literature, a novel dynamic regime-switching option-pricing
model is developed in this thesis, to overcome the flaws of the traditional option pricing
models. Five macroeconomic indicators are identified as the drivers of economic
states over time. Two regimes are selected among all likely numbers of regimes under
the Bayes Information Criterion (BIC). Both in-sample and out-of-sample tests are
constructed to examine the prediction of the model. Empirical results show that the
two-state regime-switching option-pricing model exhibits significant prediction power.

Identiferoai:union.ndltd.org:LACETR/oai:collectionscanada.gc.ca:NSHD.ca#10222/36253
Date23 August 2013
CreatorsMa, Zongming Jr
Source SetsLibrary and Archives Canada ETDs Repository / Centre d'archives des thèses électroniques de Bibliothèque et Archives Canada
Languageen_US
Detected LanguageEnglish

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