Abstract
This paper develops a new tree method for pricing financial derivatives in a regime-switching mean-reverting model. The tree achieves full node recombination and grows linearly as the number of time steps increases. Conditions for non-negative branch probabilities are presented. The weak convergence of the discrete tree approximations to the continuous regime-switching mean-reverting process is established. To illustrate the application in mathematical finance, the recombining tree is used to price commodity options and zero-coupon bonds. Numerical results are provided and compared.
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