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Pricing derivatives in a regime switching market with time inhomogenous volatility

ABSTRACT This paper studies pricing derivatives in a componentwise semi-Markov (CSM) modulated market. We consider a financial market where the asset price dynamics follows a regime switching geometric Brownian motion model in which the coefficients depend on finitely many age-dependent semi-Markov processes. We further allow the volatility coefficient to depend on time explicitly. Under these market assumptions, we study locally risk minimizing pricing of a class of European options. It is shown that the price function can be obtained by solving a non-local Black–Scholes–Merton-type PDE. We establish existence and uniqueness of a classical solution to the Cauchy problem. We also find another characterization of price function via a system of Volterra integral equation of second kind. This alternative representation leads to computationally efficient methods for finding price and hedging. An explicit expression of quadratic residual risk is also obtained.