Option pricing and hedging in different cyclical structures: a two-dimensional Markov-modulated model

The critical role of interest rate risk and associated regime-switching risk in pricing and hedging options is examined using a closed-form valuation model. Equity call options are valued under the proposed 2-dimensional Markov-modulated model in which asset prices and interest rates exhibit Markov regime-switching features. In addition, the relationship between cyclical structures and option prices are analyzed using a time-varying transition probability matrix. The proposed model can enhance the forecast transition probabilities in an out-sample period. The cycle-stylized effect of an economy exhibits different impacts on option prices and hedging strategies in a short- and a long-cycle economy. Our closed-form formula based on more realistic specifications with respect to business-cyclical structures in various financial markets is more appropriate for pricing and hedging options.