Association Journal of CSIAM
Supervised by Ministry of Education of PRC
Sponsored by Xi'an Jiaotong University
ISSN 1005-3085  CN 61-1269/O1

Chinese Journal of Engineering Mathematics ›› 2015, Vol. 32 ›› Issue (4): 475-484.doi: 10.3969/j.issn.1005-3085.2015.04.001

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Construction of Equivalent Martingale Measure in the Regime-switching Model

ZHAO Pan1,2,3,   XIAO Qing-xian1   

  1. 1- Business School, University of Shanghai for Science and Technology, Shanghai 200093
    2- College of Finance and Mathematics, West Anhui University, Lu'an, Anhui 237012
    3- Financial Risk Intelligent Control and Prevention Institute of West Anhui University, Lu'an, Anhui 237012
  • Received:2014-04-08 Accepted:2015-04-16 Online:2015-08-15 Published:2015-10-15
  • Supported by:
    The National Natural Science Foundation of China (11171221); the First-class Discipline Foundation of Shanghai (XTKX2012); the Excellent Youth Foundation of Anhui Province (2012SQRL196); the Excellent Youth Key Foundation of Anhui Province (2013SQRL071ZD).

Abstract:

Price models with regime switching can describe the impact of macroeconomics. However, when constructing an equivalent martingale measure to price financial derivatives, the equivalent martingale measure obtained by the traditional Esscher transform considers only micro-marketing risks but not macroeconomic risks represented by the regime switching. In addition, the classical geometric Brownian motion can not characterize higher peak and fat tail phenomena of asset returns. In this paper, firstly, by using a Markov process and a non-extensive maximum entropy distribution, a new price model which can describe both the phenomena of higher peak, fat tail and regime-switching is constructed. Then, by utilizing the martingale theory and the product of the price process of micro market and the Markov process of macroeconomics, a new method for constructing equivalent martingale measure is provided. The equivalent martingale measure obtained by this approach includes two kinds of risks: micro-marketing risks and macroeconomic risks. Finally, under the resulted equivalent martingale measure, the necessary and sufficient conditions are given with which the discounted asset price process can become a martingale. The results provide a theoretical basis for further studying derivative pricing and risk control.

Key words: Tsallis entropy, Markov switching, equivalent martingale measure

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