The impact of volatility regime dynamics on option pricing

Abstract

This paper explores the joint impact of stochastic volatility and Markov regime switches on option pricing. Our findings suggest that the interaction between different regimes of stochastic volatility can be adequately captured by expanding the option price asymptotically to the second order. Through our sensitivity analysis, we demonstrate the significance of the volatility level, as reflected in the second order term, in explaining the regime shift in option pricing. Furthermore, numerical and empirical experiments indicate that the adjusted closed-form formula can enhance the accuracy and efficiency of at-the-money option pricing, increasing its viability for practical applications.