Option pricing in a regime switching stochastic volatility model

Arunangshu Biswas, Anindya Goswami and Ludger Overbeck

Statistics & Probability Letters, 2018, vol. 138, issue C, 116-126

Abstract: We consider a regime switching stochastic volatility model where the stock volatility dynamics is a semi-Markov modulated square root mean reverting process. Under this model assumption, we find the locally risk minimizing price of European type vanilla options. The price function is shown to satisfy a non-local degenerate parabolic PDE which can be viewed as a generalization of the Heston PDE. The related Cauchy problem involving the PDE is shown to be equivalent to an integral equation (IE). The existence and uniqueness of solution to the PDE is carried out by studying the IE and using the semigroup theory.

Keywords: Cauchy problem; Föllmer–Schweizer decomposition; Heston model; Option pricing; Regime switching models (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (4)

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DOI: 10.1016/j.spl.2018.02.056

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