PT  - JOURNAL ARTICLE
AU  - Michèle Breton
AU  - Mbaye Ndoye
TI  - Analytical Valuation of Compound Options Under Regime-Switching Dynamics
AID  - 10.3905/jod.2021.1.139
DP  - 2021 Jul 30
TA  - The Journal of Derivatives
PG  - jod.2021.1.139
4099  - https://pm-research.com/content/early/2021/07/30/jod.2021.1.139.short
4100  - https://pm-research.com/content/early/2021/07/30/jod.2021.1.139.full
AB  - We propose an analytical formula for the evaluation of compound options when the underlying asset is described by a two-states Markov regime-switching log-normal model. This model has been shown to capture several empirical properties of market returns, and often performs better than more complex econometric models when predicting the behavior of stocks or indexes. Many traded financial products can be expressed or approximated as a combination of compound options and other simpler instruments. One specific application of interest is the pricing of principal protected notes with an early redemption feature. Our approach provides practitioners with a Black-Scholes-type formula under a realistic assumption about market prices behavior. We report on numerical experiments evaluating the sensitivity of principal protected callable notes to the model specification.TOPICS: Security analysis and valuation, quantitative methods, statistical methods, derivatives, options, performance measurementKey Findings▪ We propose an analytical formula for compound options under regime-switching dynamics.▪ We apply the formula to the evaluation of principal protected notes with a redemption feature.▪ We provide numerical illustrations using market data.