Pricing Options and Equity-Indexed Annuities in a Regime-Switching Model by Trinomial Tree Method

A Talk by Hailiang Yang, Department of Statistics and Actuarial Science, The University of Hong Kong

Presented by the The Morton L. Topfer Chair Lecture Series and the Department of Finance and Risk Engineering

Abstract

The Markov regime-switching model (MRSM) has recently become a popular model. The MRSM allows the parameters of the market model depending on a Markovian process, and the model can reflect the information of the market environment. We present a fast and simple trinomial tree model to price options in MRSM. In recent years, the pricing of modern insurance products, such as Equity-Indexed annuity (EIA) and variable annuities (VAs), has become a popular topic. These products can be considered investment plans with associated life insurance benefits, a specified benchmark return, a guarantee of an annual minimum rate of return and a specified rule of the distribution of annual excess investment return above the guaranteed return. EIA usually has a long maturity time, hence it is not appropriate to assume that the interest rate and the volatility of the equity index are constants. One way to deal with this problem is to apply the regime switching model. However, the valuation of derivatives in such model is challenging when the number of states are large, especially for the strong path dependent options such as Asian options. Our trinomial tree model provides an efficient way to solve this problem. (This is a joint work with Kevin F. L. Yuen)

About the Speaker

Hailiang Yang received his Ph.D from University of Alberta, Canada, and is an Associate of Society of Actuaries. He is a Professor at the Department of Statistics and Actuarial Science, The University of Hong Kong. His research interests are on mathematical finance and actuarial science. He has published over 100 papers in these fields. He serves as a member in the editorial boards of several journals including Insurance: Mathematics and Economics, Stochastics and Acta Mathematicae Applicatae Sinica. He is an elected member of International Statistical Institute.