Pricing and hedging barrier options under a Markov-modulated double exponential jump diffusion-CIR model

• Published in: International review of economics & finance 2018-07, Vol.56, p.330-346
• Main Authors: Chen, Son-Nan, Hsu, Pao-Peng
• Format: Article
• Language: English
• Subjects: Barrier options; Double exponential jump diffusion process; Hidden Markov chain
• ISSN: 1059-0560; 1873-8036
• DOI: 10.1016/j.iref.2017.11.003

A semi-closed-form valuation model is presented for barrier options whose underlying asset follows a mean-reverting and regime-switching double exponential jump diffusion process, and the interest rate is modulated by a mean-reverting square root model. The proposed model captures the impact of regime-switching uncertainty on barrier option prices and their hedge parameters in long and short business cycles. The model provides richer economic insight and is more appropriate for valuing barrier options in commodity markets as well as in equity and foreign-exchange markets, when an economy faces regime-switching uncertainty. •Asset value follows a regime-switching double exponential jump diffusion process.•The interest rate is modulated by the Cox-Ingersoll-Ross model.•The economic intuitions of parameters are analyzed in the bear and bull markets.•Single barrier-options prices and their hedge parameters are derived.•The potential applications of barrier options are provided under regime-shifting uncertainty.