Assume an underlying price process with the following properties:1)Its identified by two distinct regimes a low level-low vol one where the process evolves fluctuating within certain limited boundaries and a high level-high vol. 2) The transition from the Low regime to the High one, takes place rapidly through unpredictable, in time and magnitude, jumps. On the other hand, the transition from High to Low regime seems to be more smooth and gradual. 3) The length of time periods spent within each these two regimes is stochastic and not symmetric, Low regime period is significantly longer than high regime period.What is your proposal for the most proper models-methodology to price options on such a process? Thanks in advance

Optimal Hedge Monte Carlo

QuoteOriginally posted by: AnthisAssume an underlying price process with the following properties:1)Its identified by two distinct regimes a low level-low vol one where the process evolves fluctuating within certain limited boundaries and a high level-high vol. 2) The transition from the Low regime to the High one, takes place rapidly through unpredictable, in time and magnitude, jumps. On the other hand, the transition from High to Low regime seems to be more smooth and gradual. 3) The length of time periods spent within each these two regimes is stochastic and not symmetric, Low regime period is significantly longer than high regime period.What is your proposal for the most proper models-methodology to price options on such a process? Thanks in advanceSounds like regime switching?A while ago I wrote the following:http://papers.ssrn.com/sol3/papers.cfm? ... d=838924If you think it is useful, you could find some presentations and more details at www.theponytail.netKyriakos

A few random observations/suggestions:1) My first inclination is to use numerical methods -- which can simulate arbitrarily complex patterns of behavior.2) The type of solution might depend on the duration of the option relative to the durations of the regimes. If Duration_Option << Duration_Regime, then a regime-specific pricing approach should work. If the Duration_Option >> Duration_Regime, then pricing can average across a large N of regime cycles.3) If you are pricing options that are deep OTM during one regime or the other, then you might be able to use a approximation that is tied to the other regime (modulated by the probability of that regime occurring)