# American Institute of Mathematical Sciences

April  2006, 2(2): 177-197. doi: 10.3934/jimo.2006.2.177

## Option pricing under threshold autoregressive models by threshold Esscher transform

 1 Department of Actuarial Mathematics and Statistics, Heriot-Watt University, Edinburgh, United Kingdom 2 London School of Economics, United Kingdom 3 Department of Statistics and Actuarial Science, The University of Hong Kong, Pokfulam Road, Hong Kong, China

Received  September 2005 Revised  January 2006 Published  April 2006

This paper develops a valuation model for options under the class of self-exciting threshold autoregressive (SETAR) models and their variants for the price dynamics of the underlying asset using the self-exciting threshold autoregressive Esscher transform (SETARET). In particular, we focus on the first generation SETAR models first proposed by Tong (1977, 1978) and later developed in Tong (1980, 1983) and Tong and Lim (1980), and the second generation models, including the SETAR-GARCH model proposed in Tong (1990) and the double-threshold autoregressive heteroskedastic time series model (DTARCH) proposed by Li and Li (1996). The class of SETAR-GARCH models has the advantage of modelling the non-linearity of the conditional first moment and the varying conditional second moment of the financial time series. We adopt the SETARET to identify an equivalent martingale measure for option valuation in the incomplete market described by the discrete-time SETAR models. We are able to justify our choice of probability measure by the SETARET by considering the self-exciting threshold dynamic utility maximization. Simulation studies will be conducted to investigate the impacts of the threshold effect in the conditional mean described by the first generation model and that in the conditional variance described by the second generation model on the qualitative behaviors of the option prices as the strike price varies.
Citation: Tak Kuen Siu, Howell Tong, Hailiang Yang. Option pricing under threshold autoregressive models by threshold Esscher transform. Journal of Industrial & Management Optimization, 2006, 2 (2) : 177-197. doi: 10.3934/jimo.2006.2.177
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