Option Pricing Under the Markov-switching Framework Defined by Three States

An exact solution for the valuation of the options of the European style can be obtained using the Black-Scholes model. However, some of the limitations of the Black-Scholes model are said to be inconsistent such as the constant volatility of the stock price which is not the case in real life. In this thesis, the Black-Scholes model is extended to a model where the volatility is fully stochastic and changing over time, modelled by Markov chain with three states - high, medium and low. Under this model, we price options of both types, European and American, using Monte Carlo simulation