Assessing the costs of protection in a context of switching stochastic regimes

We consider the problem of cost assessment in the context of switching stochastic regimes. The dynamics of a given asset include a background noise, described by a Brownian motion and a random shock, the impact of which is characterized by changes in the coefficient diffusions. A particular economic agent that is directly exposed to variations in the underlying asset price, incurs some costs, , when the underlying asset price reaches a certain threshold, L. Ideally, the agent would make advance provision, or hedge, for these costs at time 0. We evaluate the amount of provision, or the hedging premium, , for these costs in the disrupted environment, with changes in the regime for a given time horizon, and analyse the sensitivity of this amount to possible model misspecifications.

en

application/pdf

http://eprints.lse.ac.uk/42431/1/Assessing_the_costs_of_protection_in_a_context_of_switching_stochastic_regimes%28lsero%29.pdf