Study on Split-Step Backward Euler Scheme for Regime Switching Model

This paper presents method for split-step backward Euler scheme in regime-switching models. We generalize the classical Black-Scholes model to encompass regime-switching properties. The Black-Scholes model is shown to generate significant pricing errors when a regime-switching process governs underlying asset returns. In addition, regime-switching option values are shown to generate implied volatility commonly found in empirical studies. Numerical simulation show that the approximation formula provides an efficient and reliable implementation tool for option pricing.