As the title suggests, I am currently trying to implement a dual regime-switching options pricing model. In its simplest form, I am fitting a risk-neutral GARCH(1,1) to a crash and normal regime. However, because the volatility in the crash regime is higher, I am finding that the options actually have higher prices in the crash regime. I am wondering how to reconcile this, or introduce a term that provides a negative relationship between returns and vol. But I don't know how to do this, as risk neutral pricing implies the discounted expected value of an option must be the risk-free rate. Thanks!

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    $\begingroup$ A warm welcome to Quant.SE - there is a rich literature on option pricing in the face of regime-switching behaviour - did you do some digging? $\endgroup$ – vonjd Apr 10 at 7:27
  • $\begingroup$ Yep! I mainly tried Duan's paper: faculty.weatherhead.case.edu/ritchken/documents/…. But I couldn't really understand much of it :( $\endgroup$ – Jason Apr 10 at 8:49
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    $\begingroup$ Does this help: quant.stackexchange.com/a/8252/12 and quant.stackexchange.com/a/107/12 ? $\endgroup$ – vonjd Apr 10 at 10:18
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    $\begingroup$ Would be nice if you could upvote the answers then :-) ... just saying ;-) $\endgroup$ – vonjd Apr 10 at 15:19
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    $\begingroup$ honest pay for honest work :p $\endgroup$ – Jason Apr 10 at 15:55

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