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Assessing the Costs of Protection in a Context of Switching Stochastic Regimes

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  • Pauline Barrieu
  • Nadine Bellamy
  • Jean-Michel Sahut

Abstract

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.

Suggested Citation

  • Pauline Barrieu & Nadine Bellamy & Jean-Michel Sahut, 2012. "Assessing the Costs of Protection in a Context of Switching Stochastic Regimes," Applied Mathematical Finance, Taylor & Francis Journals, vol. 19(6), pages 495-511, December.
    • Handle: RePEc:taf:apmtfi:v:19:y:2012:i:6:p:495-511
    DOI: 10.1080/1350486X.2011.642615
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    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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