TITLE:
Option Pricing and Hedging for Discrete Time Regime-Switching Models
AUTHORS:
Bruno Rémillard, Alexandre Hocquard, Hugo Lamarre, Nicolas Papageorgiou
KEYWORDS:
Option Pricing, Dynamic Hedging, Regime-Switching, Goodness-of-Fit, Hidden Markov Models
JOURNAL NAME:
Modern Economy,
Vol.8 No.8,
August
4,
2017
ABSTRACT: We propose optimal mean-variance dynamic hedging
strategies in discrete time under a multivariate Gaussian regime-switching
model. The methodology, which also performs pricing, is robust to time-varying
and clustering risk observed in financial time series. As such, it overcomes
the main theoretical drawbacks of the Black-Scholes model. To support our
approach, we provide goodness-of-fit tests to validate the model and for
choosing the appropriate number of regimes, and we illustrate the methodology
using monthly S & P 500 vanilla options prices. Then, we present the
associated out-of-sample hedging results in the context of harvesting the
implied versus realized volatility premium. Using the proposed methodology, the
Sharpe ratio derived from the strategy doubles over the Black-Scholes
delta-hedging methodology.