Convertible Bond Valuation with Regime Switching∗

Byung-June Kim† , and Bong-Gyu Jang‡

∗ This work was supported by the Ministry of Education of the Republic of Korea and the

National Research Foundation of Korea.(NRF-2019S1A5A2A03054249)

† Corresponding Author, Department of Industrial and Management Engineering, POSTECH,

Republic of Korea. Tel: +82-54-279-2372, Fax: +82-54-279-2870, kbj219@postech.ac.kr

‡ Department of Industrial and Management Engineering, POSTECH, Republic of Korea. Tel:

+82-54-279-2864, Fax: +82-54-279-2870, bonggyujang@postech.ac.kr

Keywords: Option pricing, Convertible bond, Regime switching, Exchange option, American

exchange option

JEL classification: C29, G12, G13, G32

Declarations of interest: none.

CRediT author statement

Bong-Gyu Jang: Supervision, Writing - Review & Editing, Byung-June Kim: Conceptu-

alization, Methodology, Software, Validation, Investigation, Writing - Original Draft, Writing -

Review & Editing

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 Convertible Bond Valuation with Regime Switching

January 18, 2021.

Abstract

We present a valuation formula for convertible bonds with regime-switching market condi-

tions by decomposing the convertible bond into a coupon-bearing bond and the American-type

exchange option. A coupon-bearing bond component is modeled with a four-factor model:

a two-factor affine model for the risk-free rate and a two-factor affine model with stochastic

volatility for the credit spreads on the coupon-bearing bond component. We also derive a

new valuation formula for the American-type exchange option component.

Keywords: Option pricing, Convertible bond, Regime switching, Exchange option

JEL classification: C29, G12, G13, G32

Electronic copy available at: https://ssrn.com/abstract=3604960

1 Introduction

Various unpredictable risks, such as technological development, epidemics, and political issues, are emerg-

ing in the modern financial market, changing the market environments. Convertible bonds have both bond

and equity features, which offer bondholders two benefits: equity risk premium and an asymmetric payoff

profile which can be a good risk management tool. Convertible bondholders can receive coupons until

maturity or exchange the bonds for a predetermined number of shares of stocks before maturity. However,

the price dynamics of bonds and stocks are closely related to the ever-changing market conditions, so it

would be better consider such market conditions in convertible bond pricing.

This paper exhibits a valuation formula for the convertible bond, considering changes in the financial

market conditions, which can be implemented by Markov regime-switching models.1 We divide a con-

vertible bond into a pure corporate bond component and an American-type exchange option component.

Zhu and Zhang (2012) firstly propose a valuation model that decomposes the non-redeemable zero-coupon

convertible bond into three components: a straight bond, a warrant for exchanging the bond with prede-

termined shares of stocks, and a premium from American option feature. Finnerty (2015) also proposes an

analytic valuation model of the convertible bond by the decomposition approach. Going one step forward,

we focus on the fact that the time to maturity of convertible bonds is longer than that of options in gen-

eral. The valuation may not sufficiently reflect the long-term drastic market changes without considering

the regime switching. We tries to find a valuation formula of the convertible bond in the regime-switching

market conditions.

Few studies have examined convertible bond valuation with regime switching. Zhang and Liao (2014)

introduce a numerical approach to the Black-Scholes-type partial differential equation (PDE) for convert-

ible bond valuation, considering the regime switching and credit risk. Chan and Zhu (2015) suggest an

analytic formula for pricing convertible bonds with regime switching. However, both models have strong

assumptions on the underlying assets, e.g., time-invariant values of the risk-free rate.

On the other hand, a long lifetime of convertible bonds not only requires consideration of regime

switches for financial market but also mean-reverting structure of market variables. We assume the risk-

free rate (or instantaneous short rate), a credit spread, and the stock price have both mean-reverting and

regime-switching properties. We suggest the four-factor model of Jacobs and Li (2008), which reflects the

mean-reverting properties.

We first provide a valuation formula for the pure corporate bond component by extending a four-factor

model of Jacobs and Li (2008) into a model with multi-regimes. The four-factor model of Jacobs and Li

(2008) combines a two-factor affine model for the risk-free rate and a two-factor stochastic volatility model
1 Various studies of option pricing which consider regime changes assume that underlying asset prices follow

a regime-switching geometric Brownian motion. For instance, Naik (1993), Guo (2001), Buffington and Elliott
(2002), Jang and Roh (2009), Yoon et al. (2011), and Jang and Tae (2018) suggest option valuation models with
regime-switching geometric Brownian motions.

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for the credit spread. We also introduce an induction algorithm to calculate the value of the exchange

option component. Each option with m regimes (m ≥ 2) can be decomposed into three parts: a simple

integration part, a part representing an option value with m−1 regimes, and a part representing an option

value with single regime. Using induction, we calculate the option value with m regimes from the option

value with single regime. The single-regime option part is obtained by the analytic valuation method of

Trigeorgis (1995), in which he extended Margrabe (1978)’s European exchange option model to a model

for American exchange options by applying the pseudo-American option valuation method of Geske and

Johnson (1984).

In Section 2, we derive a generalized closed-form valuation formula for the convertible bonds. Given

the mean-reverting dynamics of interest rate, credit spread, and the logarithmic stock price process, we

develop the recursive-form valuation model of both bond components and exchange option components.

Section 3 describes the two-state regime-switching example and provides the sensitivity analysis on several

model parameters.

2 The Convertible Bond Valuation Model

2.1 Model Setup

We assume that the economic regimes follow an observable m-state Markov modulated process Xt , which

is one of the unit vectors ê1 , ê2 , ..., êm , for êk = (0, ..., 0, 1, 0, ..., 0)> ∈ Rm .2 Economic conditions depend

on the current regime state, so dynamics of state variables like short-term rate, credit spread, and the risky

asset would depend on regime switching. The m-state Markov chain Xt has an infinitesimal generator:

m
X
Q̂ := (λk,j )(k,j)∈Nm ×Nm for λk,k = − λk,j .
j=1,j6=k

with a transition rate λk,j from kth regime to jth regime for k 6= j ∈ Nm = {1, ..., m}.

The occupation time Υkt,T is cumulative time to stay in kth regime over the time interval [t, T ] with
Pm
k=1 Υkt,T = T − t. The distribution of the occupation time in regime-switching process is well known by

Buffington and Elliott (2002), Naik (1993), Guo (2001), and Fuh et al. (2003), which helps us to derive

the valuation formula for the convertible bond under regime switching. As derived by Buffington and

Elliott (2002), for any x̂ = (x1 , x2 , ..., xm−1 , 0) ∈ Rm , the characteristic function of the occupation time

Υ̂t,T = (Υ1t,T , Υ2t,T , ..., Υm−1

t,T ) is

  m−1
X    Z T 
E exp i xk Υkt,T = E exp i hx̂, Xu idu = hexp((T − t)(Q + idiag x̂))Xt , 1̂m i. (1)
k=1 t

under the physical measure P where Υ1t,T + Υ2t,T + ... + Υm

t,T = T − t, and 1̂m is m-dimensional one vector.

2 To avoid confusion, we use hat notationˆto represent vector or matrix.

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Then, we can derive the probability density function of the occupation time Υ̂t,T for general multi-state

regime-switching case by Fourier inversion theorem.3

For convertible bond pricing, it is conventional to decompose the price of the convertible bond into

the coupon-bearing bond component and the exchange option component. For the bond component,

we extend the bond price model of Jacobs and Li (2008) into a regime-switching economy. Jacobs and

Li (2008) model corporate yields with a four-factor model: a standard two-factor affine model for the

risk-free rate and a two-factor affine model with stochastic volatility for the credit spreads on corporate

bonds. The log price process of the stock is assumed to follow the mean-reverting process following Lo

and Wang (1995). In this paper, our model assumptions about mean-reverting features and economic

regime-switching features of state variables are for mid to long term maturity of the convertible bond.

First, the risk-free rate rt := h(rt,1 , ..., rt,m ), Xt i, where rt,k is the risk-free rate under kth regime, is

assumed to follow:
rt = cr + f1,t + f2,t
p
dfj,t = φj (µr,j − fj,t )dt + σr,j fj,t dZr,j,t , for j = 1, 2.

φj denotes the speed of mean reversion for both factors fj,t := h(fj,t,1 , ..., fj,t,m ), Xt i, and σr,j :=

h(σr,j,1 , ..., σr,j,m ), Xt i denotes volatility for each factor fj,t . Both parameters are constant during each

regime. Two Wiener process Zr,1,t and Zr,2,t are assumed to be independent. Then, the dynamics of two

factors fj,t,k under the risk-neutral measure Qr become

p
dfj,t = (φj µr,j − (φj + πj )fj,t )dt + σr,j fj,t dZ̃r,j,t

with the market price of risk πj := h(πj,1 , ..., πj,m ), Xt i (j = 1, 2) and two independent Wiener process

Z̃r,j,t (j = 1, 2). Following Cox et al. (1985) and Jacobs and Li (2008), the assumption about constant

market price of risk πj helps our understanding about the complex model.

In the reduced-form approach, the default event occurs following an exogenous Poisson process with

intensity st := h(st,1 , ..., st,m ), Xt i.4 Here, the intensity st can be interpreted as the instantaneous default

probability or the spread between yields of non-defaultable and defaultable corporate bonds. We assume

that the short-term credit spread st under physical measure P follows a two-factor affine process:

st,k = cs,k + s∗t,k + δ1k (f1,t,k − f¯1,t,k ) + δ2k (f2,t,k − f¯2,t,k )

√
ds∗t,k = αk s̄k − s∗t,k dt + νt,k dZs,1,t ,

√
dνt,k = γk (ν̄k − νt,k ) dt + ζk νt,k dZs,2,t ,

where νt,k indicates the instantaneous volatility of the default probability under regime k; s̄k and ν̄k
3 The density function can be represented by the Bessel function (see Guo (2001)).
4 We will keep this meaning of the notation for the parameters and state variables by omitting the regime which
implies the inner product.

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are the long-run means of s∗t,k and νt,k , respectively; αk and γk are the speed of mean reversion of s∗t,k

and νt,k , respectively; ζk is the parameter of volatility-of-volatility, which indicates the kurtosis of credit

spread; and f¯1,t,k and f¯2,t,k are the average smoothed estimates of two risk-free rate factors, f1,t,k and

f2,t,k , respectively. Two Wiener process Zs,1,t and Zs,2,t are positively correlated with coefficient ρs . We

assume that two Wiener processes Zs,j,t (j = 1, 2) of credit spreads are independent with the two Wiener

processes Zr,j,t (j = 1, 2) in the interest rate process.

Under risk-neutral measure Qs ,

√
ds∗t,k = αk s̄k − αk s∗t,k + η1,k νt,k dt + νt,k dZ̃s,1,t ,

√
dνt,k = (γk ν̄k − (γk + ζk η2,k )νt,k ) dt + ζk νt,k dZ̃s,2,t ,

where two Wiener processes Z̃s,1,t and Z̃s,2,t have correlation ρs and they are independent to Zr,j,t (j =

1, 2) in the interest rate process. ηj,k (j = 1, 2) is the prices of risk in s∗t,k and νt,k , respectively.

The risky asset St := h(St,1 , ..., St,m ), Xt i with stock St,k in kth regime is the stock paying continuous

dividend yield dt := h(dt,1 , ..., dt,m ), Xt i with dividend yield dt,k in kth regime. The share price St has

the mean-reverting process following Lo and Wang (1995) and Schwartz (1997) with dividend yield:

dSt,k /St,k = κe (µt,k − dt,k /κe − ln St ) dt + σe,k dZe,t , (2)

where µt,k and dt,k are constant in kth regime and κe is conversion speed. Ze follows a standard Wiener

process with dZe,t dZr,t = ρr,e dt and dZe,t dZs,t = ρs,e dt. The convertible bond consists of a coupon-bearing

bond component and an exchange option component. With the exchange option of the convertible bond,

the holder can convert the bond into N shares (the conversion ratio). Assuming a market price of risk πe ,

Ito’s formula leads the risk-neutral measure Qe where the log price of N shares of stock follows

N
d(ln(N St,k )) = κe (µ̃t,k − ln(N St,k )) dt + σe,k dZe,t , (3)

2
dt,k σe,k πe σe,k N
where µ̃t,k = µt,k − − − is a drift parameter for each kth regime, and Ze,t = Ze,t + πe t
κe 2κe κe
is a standard Wiener process under the risk-neutral measure Qe . Note that the every assets have a same

expected return which equals the risk-free rate under the risk-neutral measure.5 The equation (3) is

equivalent with
2
N
d(ln(N St,k )) = rt,k − dt,k − σe,k /2 dt + σe,k dZe,t .

Now, we consider the risk-neutral measure Q = Qr × Qs × Qe , which is the product measure of the

risk-neutral measures for random states.

5 Considering the typical Geometric brownian motion, we can change the equation (2) to following:


dSt,k /St,k = µt,k − dt,k dt + σe,k dZe,t .
In this case, the price of risk πe is different with the case of a mean-reverting process.

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2.2 Valuation of the Coupon-Bearing Bond Component

We consider the convertible bond with a maturity T , a face value F and a recovery rate 1 − Lk in regime k.

If the firm defaults before the maturity, the bondholder would receive a cashflow of bond value discounted

by 1 − Lk . The zero-coupon defaultable corporate bond P0 (t, T, k, 1 − Lk ) at time t with maturity T , the

face value 1, and a recovery rate 1 − Lk under regime k follows:

P0 (t, T, k, 1 − Lk ) = (1 − Lk )B0 (t, T, k) + Lk P0 (t, T, k, 0),

where B0 (t, T, k) indicates the price of zero-coupon default-free bond which has the face value 1 and

maturity T . Both prices of zero-coupon corporate bonds B0 (t, T, k) and P0 (t, T, k, 0) are given as:

  Z T  
B0 (t, T, k) = EtQ exp − ru du Xt = êk ,
t
  Z T  
P0 (t, T, k, 0) = EtQ exp − (ru + su )du Xt = êk .
t

Because most convertible bonds provide coupons, we consider continuously compounded coupon pay-

ment c. The coupon-bearing bond component P (t, T, k) at time t with maturity T under regime k values

the expected discounted future payout:

Z T
B(t, T, k) = F B0 (t, T, k) + F c B0 (t, u, k)du
t
Z T
P (t, T, k, 0) = F P0 (t, T, k, 0) + F c P0 (t, u, k, 0)du
t

So, P (t, T, k) is a portfolio of the continuum of zero-coupon bonds P0 (t, u), for u ∈ [t, T ].6 Our next step

is to derive the closed-form solution of both bond prices B0 (t, T, k) and P0 (t, T, k, 0).

Theorem 2.1. Let

Z T 
M(x̂, Xt , t, T ) := E Q hx̂, Xu idu Xt
t

be the conditional expectation of any regime-switching parameter vector x̂. Let ĉb = (cb,1 , ..., cb,m ) with

cb,k = exp(cr,k ) and ĉp = (cp,1 , ..., cp,m ) with cp,k = exp(cr,k +cs,k −δ1,k f¯1,k −δ2,k f¯2,k ) be the m-dimensional
6 We can also derive B(t, T, k) and P (t, T, k, 0) with discrete coupon payment. For example, for semi-annual

coupon rate c̃, prices of both coupon-bearing bond become

2T
X 2T
X
B(t, T, k) = F B0 (t, T, k) + F c̃ B0 (t, u/2, k), P (t, T, k, 0) = F P0 (t, T, k, 0) + F c̃ P0 (t, u/2, k, 0).
u=2t u=2t

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vector of parameters. Then, the prices of zero-coupon bonds B0 (t, T, k) and P0 (t, T, k, 0) follows:

 X 
∗
B0 (t, T, k) =M(ĉb , êk , t, T ) exp Aj (τ, êk ) − Bj (τ )fj,t ,
j=1,2
 X 
∗
exp − s∗t Dk (τ ) + νt Fk (τ ) + Kk (τ ) ,


P0 (t, T, k, 0) =M(ĉp , êk , t, T ) exp Aj (τ, êk ) − Bj (τ )fj,t
j=1,2

∗
where fj,t = fj,t (1 + δj ), τ = T − t,
 Z τ  


Aj (τ, êk ) = ln exp aj (u)du 1̂m , êk , Bj (τ ) = 1 − exp(−φj τ ) /φj ,
0

>
with aj (τ ) = diag(ãj (τ )) − Q , ãj (τ ) = (ãj,1 (t), ..., ãj,m (τ )),
1
ãj,k (τ ) = µr,j,k (1 + δj )Bj (τ ) − (1 + δj )2 σr,j,k
2
Bj (τ )2 ,
2
1
and Dk (τ ) = (1 − exp(−αk τ )),
2
2iαk κk h
Fk (τ ) = − exp(αk τ )
ζk2
 
P −βj,k αk τ −αk τ dj,k
cj,k e β j,k M 1,j,k + iκk e M 2,j,k
2αk j=1,2 gj,k
+ 2 P βj,k αk τ
ζk j=1,2 cj,k e M1,j,k
Z τ Z τ
Kk (τ ) = αk s̄k Dk (u)du + γk ν̄k Fk (u)du
0 0

−αk τ
with M1,j,k = M (dj,k , gj,k , iκk e ), M2,j,k = M (dj,k + 1, gj,k + 1, iκk e−αk τ ),
1 i ρ ζ
k

dj,k = gj,k − p 2
(1 − αk η1,k ) − ρ(θk − 1) ,
2 2 1 − ρ2 αk
ζk p 1 i ρ
gj,k = 2βj,k − θk + 1, κk = 2 1 − ρ2 , h = − p
α 2 2 1 − ρ2
s
1 1 ζ2 ζ2
β1,k = βk , β2,k = θk − βk , βk = θk − θk2 − k4 + 2η1,k k3 − 2ζk h1̂m , Qêk i,
2 2 αk αk
γk + ζk η2,k ρζk
θk = + ,
αk αk

and the function M is the confluent hypergeometric function with

∞
X d(d + 1)...(d + n) hn
M (d, g, h) := 1 + .
n=1
g(g + 1)...(g + n) n!

The coefficient c1,k and c2,k are the pair which satisfy Fk (0) = 0.

Proof. see Appendix B.

Theorem 2.1 can be solved using Elliott and Siu (2009) and Selby and Strickland (1995), with the

additional term for the regime change. The difficult part of the solution is finding functions F and K, which

need the confluent hypergeometric function with complex inputs. Selby and Strickland (1995) suggests

series method to bypass this. In Section 3, we provide numerical examples with the series method to

calculate bond price.

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 Finnerty (2015) calibrated bond yields to match clean model prices and clean market prices. For each

kth regime, the equivalent continuously compounded annualized yield c̄k is

 
1 F
c̄k = ln
T −t P (t, T, k, 1 − Lk )

In Section 2.3, we will use this continuously compounded annualized yield c̄k to derive exchange option

component.

2.3 Valuation of the Exchange Option Component

Convertible bonds have the exchange-option components. Finnerty (2015) derive the analytic formula for

the European-type convertible bond.7 Convertible typically provides a stream of coupons until its long-

term maturity or exercise date, so the difference between an American option component and a European

option component can be significant. We will derive the recursive-form solution for both type of option

pricing models.

Now we take the bond component P (t, T ) (we omit third and forth element of the notation) as the

numeraire to evaluate exchange options by Margrabe (1978) approach. The equivalent martingale measure

QT satisfies R 
T
N ST exp t d · ds
" #
N St T,k
= Et R  Ft ,
P (t, T ) T
P (T, T ) exp t c̄ · ds

where EtT,k indicates the expectation under QT measure in kth regime.8 At time T , if the option is not

exercised yet, the option value εT is max {N ST − P (T, T ), 0}, regardless of its option type. The expected

discounted future payout equals the current value of the asset by martingale property. We first derive the

valuation formula for the European exchange option, then derive the valuation formula for the American

exchange option using the European exchange option values.

Theorem 2.2. When m ≥ 2, the price of the European exchange option εE

t,T,k with maturity T at time t

in the kth regime is as follows for each stock process:

7 They also derive the valuation formula for the American-type option as the maximization of the European

option values. However, the American type option should be treated dynamically, not the maximum of the European
options.
8 Note that the stock price process discounted by cashflow with the non-zero numeraire P (t, T ) should be mar-

tingale under the risk-neutral measure QT . This equation about the martingale property should hold even if we
assume a different stock price process.

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 Z   X m   µ + σ 2 (T − t) 
C
εE
t,T,k = N St exp − dk υk N √C
T −t
Υm k=1
σC T − t
m 
 X   µC
−P (t, T ) exp − c̄k υk N √
k=1
σC T − t (4)
×fk (υ1 , υ2 , ..., υm , T − t)dυ1 dυ2 ...dυm
Z
+εE,m−1
t,T,k fk (0, υ2 , ..., υm , T − t)dυ2 ...dυm + εE,0
t,T,k fk (T − t, 0, ..., 0, T − t)
T −t
Υm ,Υ1
t,T
=0

where Pm
N St exp(− υj dj ) 2
 
j=1 σC (T − t)
µC (υ1 , ..., υm ) = ln Pm − ,
P (t, T ) exp(− j=1 υj c̄j ) 2
1
Pm
σC (υ1 , ..., υm ) = T −t
σC,j υj ,
r j=1
1 − exp(−2κe (T − t))
σC,j (υ1 , ..., υm ) = σe,j .
2κe
ΥTm−t is the set of the all possible cumulative occupation time:

 m
X 
ΥTm−t := (υ1 , υ2 , ..., υm ) ∈ R m
υj = T − t, υj ≥ 0, for j = 1, 2, ..., m ,
j=1

1 2 m
and fk is the probability distribution of the set of cumulative occupation times (υt,T , υt,T , ..., υt,T ).

When m > 2, εE,m−1

t,T,k is the price of the European exchange option in the reduced-regime economy,

where the first regime never comes. On the other hand, εE,0
t,T,k is the price of the European exchange
E,m−1
option in a single regime economy in the first regime. When m = 2, εt,T,k is the single-regime European

exchange option in the second regime. By induction, we can get the general price of the European exchange

option with m-dimensional regimes.

Proof. see Appendix C.

Theorem 2.2 converges to the pricing formula of Finnerty (2015) which is a single-regime case. Note
R
that ΥT −t fk (υ1 , υ2 , ..., υm−1 )dυ2 ...dυm−1 6= 1, because integration cannot count the probabilities in the
m

boundary.9 For the boundary, we should consider the probability density function in υk = 0 or T for any

k ∈ [1, 2, ..., m − 1]. A complex shape of the boundary region can be simplified by decomposing three

cases: υ1 6= 0, υ1 = 0, and υ1 = T . For υ1 6= 0, we can integrate the state variables over occupation times.

For υ1 = 0, we can ignore the first regime and consider regime-reduced economy, where the first regime

never comes. This reduced economy has exactly same parameters with our original economy except for

the first regime. We can utilize this recursive relation. Lastly, for υ1 = T , there is no regime shift and the

regime stays in the initial regime. So we can calculate single regime case for this.

Now we consider a pseudo-American option εA

t,T,k,n which has a n discrete exercise points. At any

end points of n discrete time intervals, the option holder can exercise the exchange option.10 Because
9 Since υ
m is determined by other occupation time variables, we exclude υm in integration.
10 Discrete and finite chances of exercises would be more realistic than a continuous model for the convertible

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the discrete exercise policy is strictly sub-optimal to the continuous option, the price of the pseudo-

American exchange option εA

t,T,k,n is always a lower than the true value of American exchange option.

Geske and Johnson (1984) show that the limit of the pseudo-American option converges to continuous

American option and American option can be easily approximated by using the three-point Richardson

extrapolation.

Theorem 2.3. The pseudo-American exchange option εA

t,T,k,n is

Z  
εA
t,T,k,n = N St ω1 (υ1 , υ2 , ..., υm ) − P (t, T )ω2 (υ1 , υ2 , ..., υm ) fk (υ1 , υ2 , ..., υm , T − t)dυ1 dυ2 ...dυm
T −t
Υm
Z
+ εA,m−1
t,T,k fk (0, υ2 , ..., υm , T − t)dυ2 ...dυm + εA,0
t,T,k fk (T − t, 0, ..., 0, T − t)
T −t
Υm ,Υ1
t,T
=0

where τ = T − t,

1 Pm
ω1 ≡e− n dj υj
N1 dˆ1 (Rτ∗ /n , τ /n)


j=1

Pm

2
+ e− n N2 − dˆ1 (Rτ∗ /n , τ /n), dˆ1 (1, 2τ /n); −
dj υ j
p
j=1 1/2
Pm

3
+ e− n j=1 dj υ j
N3 − dˆ1 (Rτ∗ /n , τ /n), −dˆ1 (R2τ
∗ ˆ
/n , 2τ /n), d1 (1, τ ); Ω3

+ ...
Pm

n
+ e− n Nn − dˆ1 (Rτ∗ /n , τ /n), −dˆ1 (R2τ
j=1 dj υ j ∗ ˆ ∗ ˆ
/n , 2τ /n), ..., −d1 (R(n−1)τ /n , (n − 1)τ /n), d1 (1, τ ); Ωn ,

1 Pm
ω2 ≡e− n j=1 c̄j υj N1 dˆ2 (Rτ∗ /n , τ /n)


2 Pm
+ e− n j=1 c̄j υj N2 − dˆ2 (Rτ∗ /n , τ /n), dˆ2 (1, 2τ /n); − 1/2
p


3 Pm
+ e− n j=1 c̄j υj N3 − dˆ2 (Rτ∗ /n , τ /n), −dˆ2 (R2τ∗
/n , 2τ /n), ˆ
d 2 (1, τ ); Ω 3

+ ...
Pm

n
+ e− n j=1 c̄j υj
Nn − dˆ2 (Rτ∗ /n , τ /n), −dˆ2 (R2τ
∗ ˆ ∗ ˆ
/n , 2τ /n), ..., −d2 (R(n−1)τ /n , (n − 1)τ /n), d2 (1, τ ); Ωn ,

with Pm
1 N St e− j=1 υj dj √
   
dˆ1 (q, τ ) = ln Pm 2
+ 21 σC τ σC τ , and
q P (t, T )e− j=1 υj c̄j
√
dˆ2 (q, τ ) = dˆ1 − σC τ .

and Nj is the standard j-variate normal distribution function with a correlation matrix Ωj :

Z x1 Z xj  
1 0 −1
Nj (x1 , ..., xj ; Ωj ) ≡ ··· (2π)−j/2 |Ωj |−1/2 exp − z Ωj z dzj ...dz1 ,
−∞ −∞ 2

p
with j × 1 vector z = [z1 , ..., zj ]T , j × j symmetric matrix Ωj which has i, jth element to be i/j for i ≥ j,
∗
and Rjτ /n is the critical value at j/n, j = 1, 2, ..., n − 1. Iterative method to derive the critical values

bond.

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 ∗
Rjτ /n is presented in Appendix D.

The recursive structure of the equation is same as that of the European exchange option. When m > 2,

εA,m−1
t,T,k is the price of the American exchange option in the reduced-regime economy, where the first regime

never comes. On the other hand, εA,0

t,T,k is the price of the American exchange option in a single regime

economy in the first regime. When m = 2, εA,m−1

t,T,k is the single-regime American exchange option in

the second regime. By induction, we can get the general price of the American exchange option with

m-dimensional regimes.

Proof. see Appendix D.

Calculating the cumulative normal distribution is significantly faster than calculating the solution

of partial derivative equations by FDM or other algorithms. Furthermore, we can use the three-point

Richardson extrapolation method to approximate εA 1 A A 9 A

t,T,k,n ≈ 2 εt,T,k,1 − 4εt,T,k,2 + 2 εt,T,k,3 .

Now we have solutions for the bond component and the exchange option component. Because the con-

vertible bond consists of those two components, we can determine the analytic formula for the convertible

bond price C(P (t, T ), St , T, k) as:

C(P (t, T ), St , T, k) = P (t, T ) + lim εA

t,T,k,n
n→∞

3 A Two-State Regime-Switching Example

Now, we provide the example on two-state regime-switching model. Let the intensity λk , k = H, L of

Poisson process be the rate of leaving regime k and let fk (u, t) be the probability density function of the

occupation time Υku,t for a time 0 < t < ∞ with the initial regime k ∈ {H, L}. In regime H, the stock

volatility becomes severe (σe,H > σe,L ). Then, fk (u, t) satisfies:

  1 
λH λL u 2   
I1 2(λH λL u(t − u))1/2 + λH I0 2(λH λL u(t − u))1/2 ,

fH (u, t) = exp(λ̄)


t−u
 1 
λH λL (t − u) 2   
I1 2(λH λL u(t − u))1/2 + λL I0 2(λH λL u(t − u))1/2 ,

fL (u, t) = exp(λ̄)


u

with λ̄ := −λL (t − u) − λH u, and fH (0, t) = 0, fH (t, t) = e−λH t , fL (0, t) = e−λL t , fL (t, t) = 0,

where Ia (z) is the modified Bessel function by

∞
 z a X (z/2)2n
Ia (z) := .
2 n=0
n!Γ(a + n + 1)

Corollary 3.1. The value of the European exchange option under two-state regime switching is

Z T −t   2
  
P2 µC + σ C (T − t) P2
µC
εE
t,T,k = N St e− k=1 dk υk N √ − P (t, T )e− k=1 c̄k υk N √ fk (υ1 , T − t)dυ1
υ=0 σC T − t σC T − t

+ εE,1 E,0
t,T,k fk (0, T − t) + εt,T,k fk (T − t, T − t)

11

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and the value of the American exchange option under two-state regime switching is

Z T −t  
εA
t,T,k,n = N St ω1 (υ1 , υ2 ) − P (t, T )ω2 (υ1 , υ2 ) fk (υ1 , T − t)dυ1
υ=0

+ εA,1 A,0
t,T,k fk (0, T − t) + εt,T,k fk (T − t, T − t)

Proof. directly from Theorem 2.2 and Theorem 2.3.

In Table 1, we present the benchmark set of parameters following the calibrated results in Jacobs

and Li (2008) and parameters given in Jang and Roh (2009). Parameters of corporate yields and credit

spread in low-regime are the same as the calibrated values in Jacobs and Li (2008). The parameters of

the high-regime are those of low-regime multiplied by 0.9 or 2.0.

Parameter Low High Parameter Low High

d 0.050 0.030 λH - 1.0
σe 0.130 0.260 λL 0.5 -
cr -0.480 -0.432 cs -0.061 -0.055
f¯1 0.470 0.423 α 0.056 0.050
f¯2 0.100 0.090 s̄ 0.079 0.071
φ1 0.560 0.504 ν̄ 0.531×10-6 1.062×10-6
φ2 0.020 0.018 γ 0.077 0.069
µr,1 0.470 0.423 ζ 0.006 0.012
µr,2 0.100 0.090 ρ 0.011 -
σr,1 0.020 0.040 δ1 -0.475 -
σr,2 0.050 0.100 δ2 -0.134 -
π1 -0.030 -0.027 η1 9.956 8.960
π2 0.000 0.000 η2 -19.365 -17.429

Table 1: The benchmark parameters of a two-state regime-switching example

Figure 1 show the sensitivity analysis on selective parameters.11 The mean-reverting speed of the

first interest rate factor δ0 has a wave-shaped effect on the American option value (the subfigure (a) and

(b)). The mean-reverting speed of the credit factor α0 in the regime H has a wave-shaped effect on the

American option value in the regime H (the subfigure (c) and (d)). The American exchange option in the

regime H increases as the long-term credit factor s̄0 in the first regime increases (the subfigure (e) and

(f)). The volatility of the credit volatility zeta0 in the regime H has a wave-shaped effect on the American

option value in regime H (the subfigure (g) and (h)). Lastly, the long term average of credit volatility ν̄0

has nearly no effect on the bond and the American exchange option (the subfigure (i) and (j)). Additional

issues about the convertible bond are stated in the Appendix A.

4 Conclusion

We provide a valuation formula for the convertible bonds with regime-switching market conditions. We

divide a convertible bond into a pure corporate bond component and an American-type exchange option
11 Since we approximate the American option value with the three-point Richardson extrapolation method, there

might be some numerical errors.

12

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component. We provide a valuation formula for the pure corporate bond component under the four-factor

model of Jacobs and Li (2008). We assume that each factor is modeled to reflect the mean-reverting

properties of the risk-free interest rate and the credit spread. We also find a numerical approach to get

the value of the exchange option component under the assumption of the regime-switching and mean-

reverting underlying stock price. Specifically, we introduce a new recursive approach to get the exchange

option with multi-regimes. Furthermore, we provide a two-state regime-switching example and show the

sensitivity analysis on selective parameters.

13

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 (a) δ0 in regime H (b) δ0 in regime L

(c) α0 in regime H (d) α0 in regime L

(e) s̄0 in regime H (f ) s̄0 in regime L

(g) ζ0 in regime H (h) ζ0 in regime L

(i) ν̄0 in regime H (j) ν̄0 in regime L

Figure 1: Sensitivity analysis

14

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References

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agement Science, 54(6):1176–1188.

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Finance, 9(7):819–825.

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Jang, B.-G. and Tae, H.-W. (2018). Option pricing under regime switching: Integration over simplexes

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A Appendix. Issues about Convertible Bond Exercise

A.1 Dividend Protection

Convertible bonds on a dividend-paying stock can have dividend protection and dividend-protected con-

vertible bonds adjust its conversion ratio to offset ex-dividends. So, the price dynamics of N shares of the

stocks in the equation (3) can be adjusted by simply setting dt,k = 0 for all k as:

N
d(ln(N St,k )) = κe (µ̃t,k − ln(N St,k )) dt + σe,k dZe,t ,

2
σe,k λσe,k
where µ̃t,k = µt,k − − and the conversion ratio Nt is adjusted by:
2κe κe

St
Nt = Nt− × .
St − div

Nt− and Nt are the conversion ratio before and after the dividend payment div per share, respectively.

Finnerty (2015) compiled statistics on 386 convertible bonds issued over the period 2003-2013 and

showed increasing trend of dividend-protection. Recent convertible bond issues tend to be either non-

redeemable or both callable and putable. In the investment-grade notes, 49.23% of non-redeemable and

50.00% of both callable and putable notes were dividend-protected. In the non-investment-grade and

not-rated notes, 55.89% of non-redeemable and 36.03% of both callable and putable notes were dividend-

protected.

Most up-to-date convertible bonds are becoming dividend-protected, which makes it hard to find call

delay phenomenon. Grundy and Verwijmeren (2016) investigated 471 callable convertibles issued during

the period 2000-2008 and found that 60.08% of convertible bond samples were dividend-protected with

an increasing trend. They found a close connection between call delay and dividend payout of callable

convertible bonds; call delay is near zero for dividend-protected convertible bonds. The reasons why the

dividend policy of the firm influences call delay have been studied in various ways ( Ingersoll Jr, 1997b;

Constantinides, 1987; and Asquith and Mullins Jr, 1991). However, in the recent convertible bond design,

the issue of call delay fade away because the dividend-protected feature becomes dominant.

A.2 Dilution of Stock Price after Exercise of Convertible Bonds

With dilution after exercise of convertible bonds, the stock price dynamics in the equation (3) can be

adjusted by:

2

d(ln(N̄ St,k )) = rt,k − dt,k − σe,k /2 + σe,k dZe .

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 N0 N
where N̄ = N0 +N
with the number of newly-issued shares N0 before exercise date. However, this revised

conversion ratio ignores the impact of stock prices due to the diluted performance of the firm or the

accounting structural changes arisen from the conversion from debt to capital.

For example, earning announcement drift is a factor that significantly affects stock prices before and

after the financial disclosure date. Marquardt and Wiedman (2005) found that firms design their con-

vertible bond to manage diluted earnings per share (EPS). Furthermore, Marquardt and Wiedman (2007)

showed that managers who have bonus contracts based on EPS are willing to bear costs, and to restruc-

ture, or to redeem existing contingent convertible securities. If the stock price fluctuation due to dilution

is proportional to the stock price, we can changethe stock price dynamics by multiplying the conversion

ratio by the adjusted multiplier.

B Appendix. Proof of the Theorem 2.1

∗ ∗
Let f1u = f1u (1 + δ1 ) and f2u = f2u (1 + δ2 ). Decomposition of two bond prices leads to:

  Z T  
B0 (t, T, k) =EtQ exp − ru du Xt
t
  Z T     Z T     Z T  
∗ ∗
=EtQ exp − cr du Xt EtQ exp − f1u du Xt EtQ exp − f2u du Xt ,
t t t
  Z T  
P0 (t, T, k, 0) =EtQ exp − (ru + su )du Xt
t
  Z T     Z T  
=EtQ exp − (cr + cs − δ1 f¯1t − δ2 f¯2t )du Xt EtQ exp − s∗u du Xt
t t
  Z T     Z T  
∗ ∗
EtQ exp − f1u du Xt EtQ exp − f2u du Xt .
t t

 RT ∗

The first term of each bond price can be expressed with function M(x̂). The last two terms E Q exp − t fj,u du

(j = 1, 2) for bond prices is same as the bond price with interest rate processes with Cox–Ingersoll–Ross

model. Pearson and Sun (1994) show the simple closed-form solution without regime-switching condition,

and Elliott and Siu (2009) derive the closed-form solution with regime-switching condition. Following

Elliott and Siu (2009),

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  Z T 
∗ ∗
E Q exp − fj,u du = exp(Aj (τ, X) − Bj (τ )fj,t )
t

where τ = T − t,


Bj (τ ) = 1 − exp(−φj τ ) /φj ,
 Z τ  
Aj (τ, êk ) = ln exp a(u)du 1̂m , êk ,
0

T
with a(τ ) = diag(ã(τ )) − Q , ã(τ ) = (ã1 (τ ), ..., ãm (τ )),
1
and ãk (τ ) = µr,j,k (1 + δj )Bj (τ ) − (1 + δj )2 σr,j,k
2
Bj (τ )2 .
2

RT
Our next step is to derive EtQ exp − t s∗u du Xt . Let



  Z T  
s∗u du Xt = exp − s∗t D(τ, X) + νt F (τ, X) + K(τ, X) .


G(t, T, X) := EtQ exp −
t

From Feynman-Kac formula, we can get the partial differential equation about G.

∂2G ∂2G ∂2G

 
∂G ∂G ∂G 1
+ ∗ ds∗t + dνt + + +2 − G = 0. (B. 1)
∂τ ∂st ∂νt 2 ∗2
∂st 2
∂νt ∂νt ∂s∗t

The partial derivatives of G with respect to variables are

∂G
= (−s∗t D0 + νt F 0 + K 0 )G + hG, QXt i
∂τ
∂G ∂2G
= −DG, = D2 G (B. 2)
∂s∗t ∂s∗t 2
∂G ∂2G ∂2G
= F G, = F 2 G, = −DF G.
∂νt ∂νt2 ∂νt ∂s∗t

Substituting the system of derivatives (B. 2) to the equation (B. 1) of PDE leads to the system of the

ordinary differential equations:

D0 + αD − 1 = 0, D(0) = 0
1 2 2 1
F0 = ζ F − (γ + ζη2 )F − ρζDF − η1 D + D2 + h1̂m , QXt i, F (0) = 0 (B. 3)
2 2
K 0 = αs̄D + γ ν̄F, K(0) = 0

where D0 = ∂D/∂τ , F 0 = ∂F/∂τ , K 0 = ∂K/∂τ , and 1̂m is the m-dimensional all-ones vector. The solution
1
D(τ ) = (1 − exp(−ατ )) can be simply solved, and the function K(τ ) can be derived directly from D
2
and F . Therefore, finding F in the second equation of the system, which is a Riccati equation, is the only

difficult part left. Selby and Strickland (1995) show that the complex Riccati equation can be transformed

into a second order linear ODE by simple substitution, and derive the solution by using a series solution

method. However, in our problem in the equations (B. 3), we have additional term h1̂m , QXt i.

19

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 Note that the second equation in the system of equations (B. 3) is also the system of m equations of

multi-state regimes. So, for each regime k, we need to solve

1 2 2 1
Fk0 = ζk Fk − (γk + ζk η2,k + ρζk Dk )Fk − η1,k Dk + Dk2 + h1̂m , Qêk i, Fk (0) = 0. (B. 4)
2 2

1 2Rs 
We perform a substitution Hk (s) = exp −
ζk t Fk (u)du , following Selby and Strickland (1995) and
2
Jacobs and Li (2008). Under this substitution, we can rewrite the function Fk and Kk as:

2 Hk0 (τ )
Fk (τ ) = ,
ζk2 Hk (τ )
2γk ν̄k
Kk (τ ) = s¯k (Dk (τ ) − τ ) − ln Hk (τ ).
ζk2

Therefore, the equation (B. 4) becomes the second order linear ODE as:

ζk2
 
1 2
Hk00 + (γk + ζk η2,k + ρζk Dk )Hk0 + Dk − η1,k Dk + h1̂m , Qêk i Hk = 0. (B. 5)
2 2

A further substitution

1
τ =− ln(x), 0 ≤ x ≤ 1; and Hk (τ ) = xβk Jk (x)
αk

transform the equation (B. 5) to another second order linear ODE for Jk as:

ζk2 ζk2
   
ρζk ζk ρβk
xJk00 (x) 0
+ 2βk − θ + 1 + 2 Jk (x) + − (1 − αk η1,k ) + Jk (x) = 0 (B. 6)
αk αk2 2αk4 4αk4
r
1 1 ζ2 ζ2 γk + ζk η2,k ρζk
where βk = θk − θk2 − k4 + 2η1,k k3 − 2ζk h1̂m , Qêk i, and θk = +
2 2 α α α α

Because the differential equation (B. 6) is the identical equation, βk and θk is derived as above. The

structure of the last second order ordinary differential equation for Jk is same as that of Selby and

Strickland (1995), only except for the values of parameters βk and θk . So we can follow them with the

rest of the problem-solving by the series method.

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C Appendix. Proof of the Theorem 2.2

εE
 
t,T,k εT
= EtT,k RT Ft
P (t, T ) c̄X ds
 P (T, T )e t s
  
− tT c̄Xs ds
R N ST − P (T, T )
= EtT,k
e max , 0 Ft
Z  R P(T, T )  
T,k − tT c̄Xs ds N ST
= Et e max − 1, 0 Υkt,T = υj for j ∈ {1, 2, ..., m}
T −t
Υm P (T, T )
×fk (υ1 , υ2 , ..., υm )dυ1 dυ2 ...dυm
εE,m−1 εE,0
Z
t,T,k t,T,k
+ fk (0, υ2 , ..., υm )dυ2 ...dυm + fk (T − t, 0, ..., 0)
P (t, T ) Υm T −t
,Υ1 =0 P (t, T )
Z t,T    
Pm
N ST
= e− k=1 c̄k υk EtT,k max − 1, 0 Υjt,T = υj for j ∈ {1, 2, ..., m}
ΥmT −t P (T, T )
×fk (υ1 , υ2 , ..., υm )dυ1 dυ2 ...dυm
εE,m−1 εE,0
Z
t,T,k t,T,k
+ fk (0, υ2 , ..., υm )dυ2 ...dυm + fk (T − t, 0, ..., 0).
P (t, T ) Υm T −t
,Υ1 =0 P (t, T )
t,T

Then,
   
N ST
EtT,k max − 1, 0 Υkt,T = υk for k ∈ {1, 2, ..., m}
P (T, T )
Z ∞  (ln(N ST /P (T ,T ))−µC )2
N ST 1 −
2σ 2 (T −t) 1
= −1 p e C d (N ST /P (T, T )),
1 P (T, T ) 2πσC (T − t) (N ST /P (T, T ))

where
   
N ST
µC (υ1 , ..., υm ) = EtT,k ln Υkt,T = υk for k ∈ {1, 2, ..., m}
P (T, T )R
T RT
N ST e t dXs ds e− t dXs ds j σ 2 (T − t)
  
T,k
= ln Et RT RT Υt,T = υj for j ∈ {1, 2, ..., m} − C
P (T,
PmT )e
c̄ ds − c̄ ds 2
 e 2
t Xs t Xs

N St e− k=1 υk dk

σC (T − t)
= ln Pm − ,
P (t, T )e− k=1 υk c̄k 2

   
2 N ST j 2
and σC= V ar ln Υt,T = υj for j ∈ {1, 2, ..., m} . σC can be calculated by σC (υ1 , ..., υm ) =
P (T, T )
Pm
k=1 σC,k υk and we can esitmate σC,k in the way Finnerty (2015) estimated:

N St e−(T −t)dk /P (t, T )e−(T −t)c̄k

   
σC,k = StdDev ln Xs = i ,
N St−1 e−(T −t+1)dk /P (t − 1, T )e−(T −t+1)c̄k
   
N ST
or calculated by StdDev ln ith regime . Because P (T, T ) = F , we only need to derive the
   P (T, T ) 
value of StdDev ln N ST ith regime . Change of numeraire does not change the variance of the risky

asset, and so we need to derive the conditional variance under QN . With the equation (3),

r
1 − exp(−2κe (T − t))
σC,k = σe,k .
2κe

21

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 N ST


 √
Let y = ln P (T,T )
− µC σC T − t. Then,

   
N ST
EtT,k max − 1, 0 Υjt,T = υj for j ∈ {1, 2, ..., m}
P (T, T )
Z ∞ √
y2
1 −
= √
(eµC +yσC T −t − 1) e 2 dy
−µC /σC T −t 2π
Z ∞ 1 √ 2 σ 2 (T −t)
  
1 − (y−σC T −t) µc + C 2 −µC
= e 2 × e dy − 1 − N √
√ 2π
−µC /σC T −t  σC T − t
2 (T −t) 2
   
σC
µ C + σ (T − t) −µ C
= eµc + 2 N √C − 1−N √ .
σC T − t σC T − t

Therefore, the equation (4) in the Theorem 2.2 holds.

D Appendix. Proof of the Theorem 2.3

εA
t,T,k,1 is exactly same with the European exchange option value:

Z  Pm Pm

εA E
N St e− dk υk
N dˆ1 (1, τ ) − P (t, T )e− k=1 c̄k υk N dˆ2 (1, τ )



t,T,k,1 = εt,T,k =
k=1
T −t
Υm

× fk (υ1 , υ2 , ..., υm )dυ1 dυ2 ...dυm

Z
+ εA,m−1
t,T,k,1 fk (0, υ2 , ..., υm )dυ2 ...dυm + εA,0
t,T,k,1 fk (T − t, 0, ..., 0).
T −t
Υm ,Υ1
t,T
=0

Bond numeraire changes the exchage option model to typical option model with strike price 1. εA
t,T,k,2 is

T
the value of an exchange option that can be exercised at 2
or at T .

Z  Pm
1
εA N St e− 2 dk υk
N1 dˆ1 (Rτ∗ /2 , τ /2)


t,T,k,2 = k=1
T −t
Υm
Pm
+N St e− N2 − dˆ1 (Rτ∗ /2 , τ /2), dˆ1 (1, τ ); − 1/2
dk υk
p

k=1

1 Pm
−P (t, T )e− 2 k=1 c̄k υk N1 dˆ2 (Rτ∗ /2 , τ /2)


Pm

−P (t, T )e− k=1 c̄k υk N2 − dˆ2 (Rτ∗ /2 , τ /2), dˆ2 (1, τ ); − 1/2
p

×fk (υ1 , υ2 , ..., υm )dυ1 dυ2 ...dυm

Z
+εA,m−1
t,T,k,2 fk (0, υ2 , ..., υm )dυ2 ...dυm + εA,0
t,T,k,2 fk (T − t, 0, ..., 0),
T −t
Υm ,Υ1
t,T
=0

where N2 (x1 , x2 ; ρ) is the standard bivariate normal distribution function at x1 and x2 with correlation ρ:
 
1 2 2
Z x1 Z x2exp − 2(1−ρ 2 ) (z1 − 2ρz1 z2 + z2 )
N2 (x1 , x2 ; ρ) ≡ p dz2 dz1 ,
−∞ −∞ 2π 1 − ρ2

and Rτ∗ /2 is the critical price ratio defined by:

1 Pm 1 Pm
Rτ∗ /2 − 1 = Rτ∗ /2 e− 2 dk υk
N dˆ1 (1, τ ) − e− 2 k=1 c̄k υk N dˆ2 (1, τ ) .



k=1

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The functional form of εA A
t,T,k,2 can be used to derive εt,T,k,3 by taking maturity
2T
3
. εA
t,T,k,3 can be exercised

T 2T T
at times 3
, 3
, or at T . At first exercise point 3
, the option will not be exercised if the opportunity cost

of exercise εA
2T /3,k,2 exceeds the cashflow from the exercise. Therefore, the first critical value Rτ∗ /3 satisfies

 
1 Pm 2 Pm
Rτ∗ /3 − 1 = Rτ∗ /3 e− 3 k=1 dk υk N1 dˆ1 (Rτ∗ /3 , τ /3) + e− 3 k=1 dk υk N2 − dˆ1 (Rτ∗ /3 , τ /3), dˆ1 (1, 2τ /3); − 1/2

p

 
1 Pm 2 Pm
− e− 3 k=1 c̄k υk N1 dˆ2 (Rτ∗ /3 , τ /3) + e− 3 k=1 c̄k υk N2 − dˆ2 (Rτ∗ /3 , τ /3), dˆ2 (1, 2τ /3); − 1/2 .

p

If the pseudo-American option were not exercised its first exercise point, two exercise points are left, and
∗ A ∗
we can find its critical point R2τ /3 just same as εt,T,k,2 . The second critical value R2τ /3 satisfies

1 Pm 1 Pm
∗ ∗ −3 dk υk
N1 dˆ1 (1, 2τ /3) − e− 3 k=1 c̄k υk N1 dˆ2 (1, 2τ /3) .



R2τ /3 − 1 = R2τ /3 e
k=1

Then we can derive εA

t,T,k,3 as:

Z  
1 Pm
εA N St e− 3 k=1 dk υk N1 dˆ1 (Rτ∗ /3 , τ /3)


t,T,k,3 =
T −t
Υm
2 Pm
+e− 3 N2 − dˆ1 (Rτ∗ /3 , τ /3), dˆ1 (1, 2τ /3); −
dk υk
p

k=1 1/2
Pm

+e− dk υk
N3 − dˆ1 (Rτ∗ /3 , τ /3), −dˆ1 (R2τ
∗ ˆ


/3 , 2τ /3), d1 (1, τ ); Ω3
k=1


1 Pm
−P (t, T ) e− 3 k=1 dk υk N1 dˆ2 (Rτ∗ /3 , τ /3)

2 Pm
+e− 3 N2 − dˆ2 (Rτ∗ /3 , τ /3), dˆ2 (1, 2τ /3); −
dk υk
p

k=1 1/2
Pm

+e− dk υk
N3 − dˆ2 (Rτ∗ /3 , τ /3), −dˆ2 (R2τ
∗ ˆ


/3 , 2τ /3), d2 (1, τ ); Ω3
k=1

×fk (υ1 , υ2 , ..., υm )dυ1 dυ2 ...dυm

Z
+εA,m−1
t,T,k,3 fk (0, υ2 , ..., υm )dυ2 ...dυm + εA,0
t,T,k,3 fk (T − t, 0, ..., 0),
T −t
Υm ,Υ1
t,T
=0

where N3 is the standard trivariate normal distribution function at x1 , x2 , and x3 with a correlation

matrix Ω3 given by

Z x1 Z x2 Z x3  
1 0 −1
N3 (x1 , x2 , x3 ; Ω3 ) ≡ (2π)−3/2 |Ω3 |−1/2 exp − z Ω3 z dz3 dz2 dz1 ,
−∞ −∞ −∞ 2

with z as the 3 × 1 vector [z1 , z2 , z3 ], and Ω3 as the 3 × 3 symmetric matrix

p p p 
 1/1 1/2 1/3
p p p 
.
 1/2 2/2 2/3

p p p 
1/3 2/3 3/3

By induction, we can derive the general pseudo-American exchange option εA

t,T,k,n in theorem 2.3.

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