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An FFT approach for option pricing under a regime-switching stochastic interest rate model

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  • Kun Fan
  • Yang Shen
  • Tak Kuen Siu
  • Rongming Wang

Abstract

In this article, we investigate the pricing of European-style options under a Markovian regime-switching Hull–White interest rate model. The parameters of this model, including the mean-reversion level, the volatility of the stochastic interest rate, and the volatility of an asset’s value, are modulated by an observable, continuous-time, finite-state Markov chain. A closed-form expression for the characteristic function of the logarithmic terminal asset price is derived. Then, using the fast Fourier transform, a price of a European-style option is computed. In a two-state Markov chain case, numerical examples and empirical studies are presented to illustrate the practical implementation of the model.

Suggested Citation

  • Kun Fan & Yang Shen & Tak Kuen Siu & Rongming Wang, 2017. "An FFT approach for option pricing under a regime-switching stochastic interest rate model," Communications in Statistics - Theory and Methods, Taylor & Francis Journals, vol. 46(11), pages 5292-5310, June.
    • Handle: RePEc:taf:lstaxx:v:46:y:2017:i:11:p:5292-5310
    DOI: 10.1080/03610926.2015.1100740
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    Cited by:

    1. Dong-Mei Zhu & Jiejun Lu & Wai-Ki Ching & Tak-Kuen Siu, 2019. "Option Pricing Under a Stochastic Interest Rate and Volatility Model with Hidden Markovian Regime-Switching," Computational Economics, Springer;Society for Computational Economics, vol. 53(2), pages 555-586, February.
    2. Xie, Yurong & Deng, Guohe, 2022. "Vulnerable European option pricing in a Markov regime-switching Heston model with stochastic interest rate," Chaos, Solitons & Fractals, Elsevier, vol. 156(C).
    3. Feng, Chengxiao & Tan, Jie & Jiang, Zhenyu & Chen, Shuang, 2020. "A generalized European option pricing model with risk management," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 545(C).

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