Rare Shock, Two-Factor Stochastic Volatility and Currency Option Pricing

Guanying Wang, Xingchun Wang () and Yongjin Wang

Applied Mathematical Finance, 2014, vol. 21, issue 1, 32-50

Abstract: In this paper, we develop an option valuation model where the dynamics of the spot foreign exchange rate is governed by a two-factor Markov-modulated jump-diffusion process. The short-term fluctuation of stochastic volatility is driven by a Cox--Ingersoll--Ross (CIR) process and the long-term variation of stochastic volatility is driven by a continuous-time Markov chain which can be interpreted as economy states. Rare events are governed by a compound Poisson process with log-normal jump amplitude and stochastic jump intensity is modulated by a common continuous-time Markov chain. Since the market is incomplete under regime-switching assumptions, we determine a risk-neutral martingale measure via the Esscher transform and then give a pricing formula of currency options. Numerical results are presented for investigating the impact of the long-term volatility and the annual jump intensity on option prices.

Date: 2014
References: Add references at CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://hdl.handle.net/10.1080/1350486X.2013.798452 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:apmtfi:v:21:y:2014:i:1:p:32-50

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RAMF20

DOI: 10.1080/1350486X.2013.798452

Access Statistics for this article

Applied Mathematical Finance is currently edited by Professor Ben Hambly and Christoph Reisinger

More articles in Applied Mathematical Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().