AMERICAN OPTIONS WITH REGIME SWITCHING

Abstract

A Black-Scholes market is considered in which the underlying economy, as modeled by the parameters and volatility of the processes, switches between a finite number of states. The switching is modeled by a hidden Markov chain. European options are priced and a Black-Scholes equation obtained. The approximate valuation of American options due to Barone-Adesi and Whaley is extended to this setting.