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Accounting for regime and parameter uncertainty in regime-switching models

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  • Hartman, Brian M.
  • Heaton, Matthew J.

Abstract

As investment guarantees become increasingly complex, realistic simulation of the price becomes more critical. Currently, regime-switching models are commonly used to simulate asset returns. Under a regime switching model, simulating random asset streams involves three steps: (i) estimate the model parameters given the number of regimes using maximum likelihood, (ii) choose the number of regimes using a model selection criteria, and (iii) simulate the streams using the optimal number of regimes and parameter values. This method, however, does not properly incorporate regime or parameter uncertainty into the generated asset streams and therefore into the price of the guarantee. To remedy this, this article adopts a Bayesian approach to properly account for those two sources of uncertainty and improve pricing.

Suggested Citation

  • Hartman, Brian M. & Heaton, Matthew J., 2011. "Accounting for regime and parameter uncertainty in regime-switching models," Insurance: Mathematics and Economics, Elsevier, vol. 49(3), pages 429-437.
    • Handle: RePEc:eee:insuma:v:49:y:2011:i:3:p:429-437
    DOI: 10.1016/j.insmatheco.2011.07.003
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    References listed on IDEAS

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    Cited by:

    1. Yoo Byoung Hark & Ko Bangwon & Kwon Hyuk-Sung, 2016. "On the Bayesian Risk Evaluation of Minimum Guarantees in Variable Annuities," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 10(1), pages 21-43, January.

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    More about this item

    Keywords

    Asset price simulation; Bayesian modeling; Dirichlet process;
    All these keywords.

    JEL classification:

    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General

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