The minimal entropy martingale measure (MEMM) for a Markov-modulated exponential Lévy model (Q431920): Difference between revisions

Suppose the price process of a risky asset is modeled by a ``Markov-modulated exponential Lévy model'', i.e., an exponential Lévy model whose drift and variance switch between different regimes driven by an independent Markov chain. In this setting, the authors characterize the so-called ``minimal entropy martingale measure'', which minimizes the relative entropy with respect to the physical probability among all martingale measures for the risky asset. The density process of this measures is found to be composed of an ``Esscher parameter'', determined as the solution of a pointwise equation which only depends on the Lévy process, and an additional matrix, determined as the solution to an auxiliary minimization problem fully governed by the dynamics of the Markov chain.