Are Regime Shift Risks Priced in Asset Markets?

Abstract

In this paper we introduce a discrete time pricing model for a European call option when the log-return of the underlying stock (asset) is subject to discontinuous market regime type of shifts in its mean or volatility whose risk can be priced in the market. The paper shows how to estimate this model and then it uses it to examine if regime shift sources of risk are priced in option markets. The results of the paper clearly indicate that stock market regime shifts constitute significant sources of risk which are priced in option markets. Ignoring these sources of risks will lead to significant option pricing errors.