Pricing variance swaps in a hybrid model of stochastic volatility and interest rate with regime-switching

2016/03/28 by Cao, Jiling, Roslan, Teh Raihana Nazirah, Zhang, Wenjun
#91B70 #91G20 #91G30 #FOS: Economics and business #Mathematical Finance (q-fin.MF) #Pricing of Securities (q-fin.PR)

paper · doi:10.48550/arxiv.1603.08289

Abstract

In this paper, we consider the problem of pricing discretely-sampled variance swaps based on a hybrid model of stochastic volatility and stochastic interest rate with regime-switching. Our modelling framework extends the Heston stochastic volatility model by including the CIR stochastic interest rate and model parameters that switch according to a continuous-time observable Markov chain process. A semi-closed form pricing formula for variance swaps is derived. The pricing formula is assessed through numerical implementations, and the impact of including regime-switching on pricing variance swaps is also discussed.

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