An exact and explicit formula for pricing lookback options with regime switching

Abstract

This paper investigates the pricing of European-style lookback options when the price dynamics of the underlying risky asset are assumed to follow a Markov-modulated Geo-metric Brownian motion; that is, the appreciation rate and the volatility of the underlying risky asset depend on unobservable states of the economy described by a continuous-time hidden Markov chain process. We derive an exact, explicit and closed-form solution for European-style lookback options in a two-state regime switching model.