VARIANCE AND VOLATILITY SWAPS UNDER A TWO-FACTOR STOCHASTIC VOLATILITY MODEL WITH REGIME SWITCHING

Xin-Jiang He () and Song-Ping Zhu
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Xin-Jiang He: School of Mathematics and Applied Statistics, University of Wollongong, Wollongong, NSW 2522, Australia
Song-Ping Zhu: School of Mathematics and Applied Statistics, University of Wollongong, Wollongong, NSW 2522, Australia

International Journal of Theoretical and Applied Finance (IJTAF), 2019, vol. 22, issue 04, 1-19

Abstract: In this paper, the pricing problem of variance and volatility swaps is discussed under a two-factor stochastic volatility model. This model can be treated as a two-factor Heston model with one factor following the CIR process and another characterized by a Markov chain, with the motivation originating from the popularity of the Heston model and the strong evidence of the existence of regime switching in real markets. Based on the derived forward characteristic function of the underlying price, analytical pricing formulae for variance and volatility swaps are presented, and numerical experiments are also conducted to compare swap prices calculated through our formulae and those obtained under the Heston model to show whether the introduction of the regime switching factor would lead to any significant difference.

Keywords: Variance swaps; volatility swaps; stochastic volatility; regime switching; Heston model; CIR model; Markov chains (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (3)

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DOI: 10.1142/S0219024919500092

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