Pricing variance and volatility swaps with stochastic volatility, stochastic interest rate and regime switching

Sha Lin and Xin-Jiang He

Physica A: Statistical Mechanics and its Applications, 2020, vol. 537, issue C

Abstract: In this paper, we propose a two-factor Heston–CIR hybrid model for the pricing of variance and volatility swaps, by introducing the second regime switching factor into the Heston–CIR hybrid model. While this model is closer to reality, taking advantages of the Heston stochastic volatility, CIR stochastic interest rate and regime switching, it has a more complicated structure and thus leads to extra difficulty in finding analytical solutions. Albeit difficult, we have still managed to present analytical pricing formulae for variance and volatility swaps, based on the derived forward characteristic function in a series form. The series solutions are accompanied by a radius of convergence to ensure its safe application, and their fast convergence demonstrated through numerical experiments facilitates the implementation in practice.

Keywords: Two-factor Heston–CIR hybrid model; Variance and volatility swaps; Regime switching; Analytical; Convergence (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:537:y:2020:i:c:s0378437119315456

DOI: 10.1016/j.physa.2019.122714

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