Option Pricing with Economic Regime Shifts

Abstract

Assuming that one-period logarithmic returns of the underlying asset follow a hidden Markov process, we develop a valuation model for European call options. Unlike existing option pricing models, our pricing mechanism relies on the optimal non exponential-affine stochastic discount factor characterized with economic strength. Monthly S\&P 500 index options for the period, January 2014 to October 2018, are used for model validation. It is found that risk/return profiles under the optimal risk neutral probability measure associated with a non exponential-affine stochastic discount factor are drastically different across the regimes of economic strength. We use both the absolute pricing error and the model-implied volatility criteria to examine model performance. In comparison with alternative models, empirically evidenced unbalanced pricing errors for deeply in-the-money and deeply out-of-the-money options are substantially reduced.