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

Jiling Cao, Teh Raihana Nazirah Roslan () and Wenjun Zhang ()
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Teh Raihana Nazirah Roslan: Auckland University of Technology
Wenjun Zhang: Auckland University of Technology

Methodology and Computing in Applied Probability, 2018, vol. 20, issue 4, 1359-1379

Abstract: 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.

Keywords: Heston-CIR hybrid model; Regime-switching; Realized variance; Stochastic interest rate; Stochastic volatility; Variance swap; 91G39; 91G20; 91B70 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (2)

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Working Paper: Pricing variance swaps in a hybrid model of stochastic volatility and interest rate with regime-switching (2016)
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DOI: 10.1007/s11009-018-9624-5

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