Exit problems in regime-switching models

This paper provides a general framework for pricing of perpetual American and real options in regime-switching Levy models. In each state of the Markov chain, which determines switches from one Levy process to another, the payoff stream is a monotone function of the Levy process labeled by the state. This allows for additional switching within each state of the Markov chain (payoffs can be different in different regions of the real line). The pricing procedure is efficient even if the number of states is large provided the transition rates are not very large w.r.t. the riskless rates. The payoffs and riskless rates may depend on a state. Special cases are stochastic volatility models and models with stochastic interest rate; both must be modeled as finite-state Markov chains. As an application, we solve exit problems for a price-taking firm, and study the dependence of the exit threshold on the interest rate uncertainty. (C) 2007 Elsevier B.V. All rights reserved.