OPTION PRICING IN A REGIME-SWITCHING MODEL USING THE FAST FOURIER TRANSFORM

This paper is concerned with fast Fourier transform (FFT) approach to option valuation, where the underlying asset price is governed by a regime-switching geometric Brownian motion. An FFT method for the regime-switching model is developed first. Aiming at reducing computational complexity, a near-optimal FFT scheme is proposed when the modulating Markov chain has a large state space. To test the FFT method, a novel semi-Monte Carlo simulation algorithm is developed. This method takes advantage of the ob-servation that the option value for a given sample path of the underlying Markov chain can be calculated using the Black-Scholes formula. Finally, numerical results are reported. Copyright © 2006 R. H. Liu et al. This is an open access article distributed under the Cre-ative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. 1