Option pricing model based on a Markov-modulated diffusion with jumps (Q985996)

This paper proposes a class of financial market models based on inhomogeneous telegraph processes and jump diffusions with alternating volatilities. The jumps are assumed to occur when the volatilities are switching. The motivation for this work stems from the fact that market dynamics cannot be described by geometric Brownian motion with constant parameters of drift and volatility. Although several authors have studied models with random drift and random volatility parameters, the author considers Markovian dependence on the past. The model presented by the author is based on standard Brownian motion and on a Markov process with two states. The author begins by defining the relevant terms. A telegraph process is a continuous time random motion with alternating velocities. The author presents an extensive list of previous work utililizing telegraph processes in finance, actuarial science, and physics. His model generalizes the classic Black-Scholes-Merton model. In this paper, the author extends the jump-telegraph market model that he presented in [Quant. Finance 7, 575--583 (2007; Zbl 1151.91535); ``An option pricing model based on jump telegraph processes'', PAMM 7, 2080009-2080010 (2007)] by adding a diffusion component. In Section 2, the author presents the definitions, introduces notation, and describes the underlying processes. In Section 3, the set of risk-neutral measures for the incomplete jump-telegraph model is presented. The author completes the model by adding another asset driven by the same source of randomness.