Consistent asset modelling with random coefficients and switches between regimes

Felix L. Wolf*, Griselda Deelstra, Lech A. Grzelak

*Corresponding author for this work

Research output: Contribution to journalArticleAcademicpeer-review

Abstract

We explore a stochastic model that enables capturing external influences in two specific ways. The model allows for the expression of uncertainty in the parametrisation of the stochastic dynamics and incorporates patterns to account for different behaviours across various times or regimes. To establish our framework, we initially construct a model with random parameters, where the switching between regimes can be dictated either by random variables or deterministically. Such a model is highly interpretable. We further ensure mathematical consistency by demonstrating that the framework can be elegantly expressed through local volatility models taking the form of standard jump diffusions. Additionally, we consider a Markov-modulated approach for the switching between regimes characterised by random parameters. For all considered models, we derive characteristic functions, providing a versatile tool with wide-ranging applications. In a numerical experiment, we apply the framework to the financial problem of option pricing. The impact of parameter uncertainty is analysed in a two-regime model, where the asset process switches between periods of high and low volatility imbued with high and low uncertainty, respectively.

Original languageEnglish
Pages (from-to)65-85
Number of pages21
JournalMathematics and Computers in Simulation
Volume223
DOIs
Publication statusPublished - Sept 2024

Bibliographical note

Publisher Copyright:
© 2024 International Association for Mathematics and Computers in Simulation (IMACS)

Funding

This research is part of the ABC\u2013EU\u2013XVA project and has received funding from the European Union\u2019s Horizon 2020 research and innovation programme under the Marie Sk\u0142odowska\u2013Curie grant agreement No. 813261 .

FundersFunder number
Amsterdam Brain and Cognition
European Commission
Horizon 2020 Framework Programme813261

    Keywords

    • Asset modelling
    • Local volatility
    • Markov-modulation
    • Randomisation
    • Switching

    Fingerprint

    Dive into the research topics of 'Consistent asset modelling with random coefficients and switches between regimes'. Together they form a unique fingerprint.

    Cite this