2004-05 FIN: Effects of Regime Switching and Stochastic Volatility on T-Bill Option Prices (Working Paper Abstract)
Kalimipalli, M., & Susmel, R.
published: 2004 | Research publication | Working Paper - Finance
ABSTRACT: In this paper, we examine the option pricing implications of introducing regime-switching specification in the two-factor interest rate models. In particular, we examine if the volatility shocks from regime-switching carry any incremental information beyond SV for option prices. We model the volatility of short-term interest rates as a stochastic volatility process whose mean is subject to shifts in regime. We find that the stochastic volatility models typically generate lower historical volatilities and hence lower option prices than constant volatility and GARCH models. Consistent with previous evidence, we find that introducing switching in a SV model has economic significance, especially during high volatility periods.
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revised Dec 9/04
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