Instantaneous mean-variance hedging and instantaneous Sharpe ratio pricing in a regime-switching financial model, with applications to equity-linked claims

TL;DR

This paper develops a framework for hedging and pricing unattainable claims in a regime-switching financial model using instantaneous mean-variance and Sharpe ratio criteria, applicable to equity-linked insurance claims.

Contribution

It introduces a novel approach combining regime-switching dynamics with instantaneous mean-variance hedging and Sharpe ratio pricing, utilizing backward stochastic differential equations.

Findings

Derived explicit hedging strategies minimizing risk.

Established pricing methods matching target Sharpe ratios.

Applied framework to equity-linked insurance claims.

Abstract

We study hedging and pricing of unattainable contingent claims in a non-Markovian regime-switching financial model. Our financial market consists of a bank account and a risky asset whose dynamics are driven by a Brownian motion and a multivariate counting process with stochastic intensities. The interest rate, drift, volatility and intensities fluctuate over time and, in particular, they depend on the state (regime) of the economy which is modelled by the multivariate counting process. Hence, we can allow for stressed market conditions. We assume that the trajectory of the risky asset is continuous between the transition times for the states of the economy and that the value of the risky asset jumps at the time of the transition. We find the hedging strategy which minimizes the instantaneous mean-variance risk of the hedger's surplus and we set the price so that the instantaneous Sharpe ratio of the hedger's surplus equals a predefined target. We use Backward Stochastic Differential Equations. Interestingly, the instantaneous mean-variance hedging and instantaneous Sharpe ratio pricing can be related to no-good-deal pricing and robust pricing and hedging under model ambiguity. We discuss key properties of the optimal price and the optimal hedging strategy. We also use our results to price and hedge mortality-contingent claims with financial components (equity-linked insurance claims) in a combined insurance and regime-switching financial model.