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Foreign exchange option pricing with a three-factor Heston model with regime switching and stochastic interest rate

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  • He, Xin-Jiang
  • Lin, Sha

Abstract

This paper introduces a novel three-factor model for pricing foreign exchange options, incorporating the dynamics of stochastic volatility, stochastic interest rates, and regime switching. The model is developed by combining the Heston stochastic volatility framework with a regime switching volatility model, where both domestic and foreign interest rates follow the Hull–White model. This approach offers several advantages, such as the effective inclusion of regime switching and the correlation between exchange rates and interest rates, while maintaining analytical tractability. The pricing formula is derived by first obtaining the characteristic function of the underlying exchange rate using measure transformation. This formula is then numerically validated, and its application is demonstrated to analyze the impact of the regime switching factors. Furthermore, an empirical analysis using real market data is conducted to assess the practical relevance of incorporating these regime switching elements into the model.

Suggested Citation

  • He, Xin-Jiang & Lin, Sha, 2025. "Foreign exchange option pricing with a three-factor Heston model with regime switching and stochastic interest rate," The North American Journal of Economics and Finance, Elsevier, vol. 80(C).
    • Handle: RePEc:eee:ecofin:v:80:y:2025:i:c:s106294082500110x
    DOI: 10.1016/j.najef.2025.102470
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    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics

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