Option Pricing Under Regime-Switching Models: Novel Approaches Removing Path-Dependence

Abstract

Although option pricing schemes in regime-switching frameworks were extensively explored in the literature, many models developed disregard the unobservability of regimes. In such a context, the traditional pricing approach pioneered by Hardy (2001) applied to vanilla options exhibits path-dependence even if the underlying asset price process can be embedded in a Markov process. This property is deemed counterintuitive and puzzling, warranting explanations and alternatives. The current work develops novel risk-neutral measures which remove the path-dependence issue. Pricing approaches based on dynamic programming and Monte-Carlo simulations which rely on the latter measures are illustrated.