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A semianalytical formula for European options under a hybrid Heston–Cox–Ingersoll–Ross model with regime switching

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  • Xin‐Jiang He
  • Wenting Chen

Abstract

In this paper, we consider the pricing of European options under a regime‐switching Heston–Cox–Ingersoll–Ross (CIR) hybrid model, where the mean‐reversion levels of both the stochastic volatility and interest rate are assumed to change among different states. Albeit difficult, we have still managed to derive an semianalytical pricing formula for European options after the generalized moment generating function of this particular model is worked out. Numerical experiments are also carried out to demonstrate the accuracy of the newly derived formula as well as the influence of the introduction of the regime‐switching mechanics on option prices. Finally, through a preliminary empirical study, our model is shown to be superior to the Heston‐CIR model, which demonstrates the importance of introducing the regime‐switching mechanics.

Suggested Citation

  • Xin‐Jiang He & Wenting Chen, 2021. "A semianalytical formula for European options under a hybrid Heston–Cox–Ingersoll–Ross model with regime switching," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(1), pages 343-352, January.
    • Handle: RePEc:wly:ijfiec:v:26:y:2021:i:1:p:343-352
    DOI: 10.1002/ijfe.1792
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    1. Bianca Reichert & Adriano Mendon a Souza, 2022. "Can the Heston Model Forecast Energy Generation? A Systematic Literature Review," International Journal of Energy Economics and Policy, Econjournals, vol. 12(1), pages 289-295.

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