Valuing Options in Regime-Switching Models

This paper presents a lattice-based method for valuing both European and American-style options in regime-switching models. In a numerical example, the Black-Scholes model is shown to generate significant pricing errors when a regime-switching process governs underlying asset returns. In addition, regime-switching option values are shown to generate implied volatility smiles commonly found in empirical studies. These results provide encouraging evidence that the valuation technique is important, and rich enough to capture salient features of traded option prices. Journal of Derivatives 6, 38-49, Fall 1998