Optimal hedging when the underlying asset follows a regime-switching Markov process

• A flexible discrete-time hedging approach for a general regime-switching framework.
• Minimization of the expected value of any desired penalty function of the hedging error.
• Backward recursion allows for the sequential construction of an optimal strategy.
• Efficient numerical implementation is described.

We develop a flexible discrete-time hedging methodology that minimizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9%0.9% and 12.6%12.6% with respect to the best benchmark.