An explicit solution to an optimal stopping problem with regime switching

Abstract

We investigate an optimal stopping time problem which arises from pricing Russian options (i.e. perpetual look-back options) on a stock whose price fluctuations are modelled by adjoining a hidden Markov process to the classical Black-Scholes geometric Brownian motion model. By extending the technique of smooth fit to allow jump discontinuities, we obtain an explicit closed-form solution. It gives a non-standard application of the well-known smooth fit principle where the optimal strategy involves jumping over the optimal boundary and by an arbitrary overshoot. Based on the optimal stopping analysis, an arbitrage-free price for Russian options under the hidden Markov model is derived.