An analytical approximation for European options under a Heston-type model with regime switching

Wenting Chen and Xin-Jiang He

The North American Journal of Economics and Finance, 2025, vol. 80, issue C

Abstract: In this paper, we consider the pricing of European options under a generalized regime-switching Heston model. By “generalized”, it means that all parameters of the original Heston model are expected to vary among various economic states. This broad assumption regarding regime switching has impeded the application of existing analytical techniques used to calculate European option prices under Heston-type regime-switching models. Albeit difficult, we have managed to derive an analytical approximation for the price of European options with the use of frozen coefficient technique. Remarkably, an error estimation for the approximation has been established theoretically and verified quantitatively through numerical experiments. Finally, through a preliminary empirical study, the current model is shown to be superior to a class of generally used Heston-type models, implying that the present model, together with the newly derived formula, can be safely used in actual financial market for pricing European options expiring in no more than three months.

Keywords: Stochastic volatility model; Option pricing; Regime-switching; Frozen coefficient technique (search for similar items in EconPapers)
JEL-codes: C02 G13 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:80:y:2025:i:c:s1062940825001408

DOI: 10.1016/j.najef.2025.102500

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