| This paper presents a lattice-based method for valuing both
European and American-style options in regime-switching models. In a numerical example, the Black-Scholes model is
shown to generate significant pricing errors when a regime-switching process governs
underlying asset returns. In addition, regime-switching option values are shown to generate
implied volatility smiles commonly found in empirical studies. These results provide
encouraging evidence that the valuation technique is important, and rich enough to capture
salient features of traded option prices. |