Accounting for regime and parameter uncertainty in regime-switching models

Abstract

As investment guarantees become increasingly complex, realistic simulation of the price becomes more critical. Currently, regime-switching models are commonly used to simulate asset returns. Under a regime switching model, simulating random asset streams involves three steps: (i) estimate the model parameters given the number of regimes using maximum likelihood, (ii) choose the number of regimes using a model selection criteria, and (iii) simulate the streams using the optimal number of regimes and parameter values. This method, however, does not properly incorporate regime or parameter uncertainty into the generated asset streams and therefore into the price of the guarantee. To remedy this, this article adopts a Bayesian approach to properly account for those two sources of uncertainty and improve pricing.