Pricing and hedging for correlation options with regime switching and common jump risk

This article investigates the pricing of the correlation options under regime switching models with common jump risk. We assume that the values of model parameters are modulated by a continuous-time, finite-state, observable Markov chain which is used to describe the states of an economy. In addition, the common jump reflects the correlated jump risk between the underlying assets. According to the Fourier transform method, we first derive the semi-analytical pricing formula for the correlation options. Then, some hedging strategies such as Greek letters and minimum variance hedging strategies are offered. Finally, we provide numerical examples to illustrate the effects of the regime switching and the common jump risk on the correlation option price by using the fast Fourier transform (FFT) algorithm.