Option Pricing and Hedging for Discrete Time Autoregressive Hidden Markov Model

In this paper we solve the discrete time mean-variance hedging problem when asset returns follow a multivariate autoregressive hidden Markov model. Time dependent volatility and serial dependence are well established properties of financial time series and our model covers both. To illustrate the relevance of our recommended approach, we first compare the proposed model with the well-known hidden Markov model via likelihood ratio tests and a novel goodness-of-fit test on the S&P 500 daily returns. In addition, we present out-of-sample hedging results on S&P 500 vanilla options as well as a trading strategy based on the difference between theoretical and market prices. This strategy is compared to simpler models including the classical Black-Scholes delta-hedging approach.