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Pricing Variance Swaps in a Hybrid Model of Stochastic Volatility and Interest Rate with Regime-Switching

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  • Jiling Cao

    (Auckland University of Technology)

  • Teh Raihana Nazirah Roslan

    (Auckland University of Technology
    Universiti Utara Malaysia)

  • Wenjun Zhang

    (Auckland University of Technology)

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 modeling framework extends the Heston stochastic volatility model by including the Cox-Ingersoll-Ross (CIR) stochastic interest rate model. In addition, certain model parameters in our model switch according to a continuous-time observable Markov chain process. This enables our model to capture several macroeconomic issues such as alternating business cycles. A semi-closed form pricing formula for variance swaps is derived. The pricing formula is assessed through numerical implementation, where we validate our pricing formula against the Monte Carlo simulation. The impact of incorporating regime-switching for pricing variance swaps is also discussed, where variance swaps prices with and without regime-switching effects are examined in our model. We also explore the economic consequence for the prices of variance swaps by allowing the Heston-CIR model to switch across three different regimes.

Suggested Citation

  • Jiling Cao & Teh Raihana Nazirah Roslan & Wenjun Zhang, 2018. "Pricing Variance Swaps in a Hybrid Model of Stochastic Volatility and Interest Rate with Regime-Switching," Methodology and Computing in Applied Probability, Springer, vol. 20(4), pages 1359-1379, December.
    • Handle: RePEc:spr:metcap:v:20:y:2018:i:4:d:10.1007_s11009-018-9624-5
    DOI: 10.1007/s11009-018-9624-5
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    Cited by:

    1. 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.
    2. Lesław Gajek & Marcin Rudź, 2020. "Finite-horizon general insolvency risk measures in a regime-switching Sparre Andersen model," Methodology and Computing in Applied Probability, Springer, vol. 22(4), pages 1507-1528, December.

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