Jiling, Cao and Roslan, Teh Raihana Nazirah and Wenjun, Zhang (2020) The valuation of variance swaps under stochastic volatility, stochastic interest rate and full correlation structure. Journal of the Korean Mathematical Society, 57 (5). pp. 1167-1186. ISSN 0304-9914

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Abstract

This paper considers the case of pricing discretely-sampled variance swaps under the class of equity-interest rate hybridization. Our modeling framework consists of the equity which follows the dynamics of the Heston stochastic volatility model, and the stochastic interest rate is driven by the Cox-Ingersoll-Ross (CIR) process with full correlation structure imposed among the state variables. This full correlation structure possesses the limitation to have fully analytical pricing formula for hybrid models of variance swaps, due to the non-affinity property embedded in the model itself. We address this issue by obtaining an efficient semi-closed form pricing formula of variance swaps for an approximation of the hybrid model via the derivation of characteristic functions. Subsequently, we implement numerical experiments to evaluate the accuracy of our pricing formula. Our findings confirm that the impact of the correlation between the underlying and the interest rate is significant for pricing discretely-sampled variance swaps.

Item Type:	Article
Uncontrolled Keywords:	Heston-CIR hybrid model, realized variance, stochastic interest rate, stochastic volatility, variance swap, generalized Fourier transform
Subjects:	Q Science > QA Mathematics
Divisions:	School of Quantitative Sciences
Depositing User:	Mrs. Norazmilah Yaakub
Date Deposited:	22 Dec 2020 01:51
Last Modified:	22 Dec 2020 01:51
URI:	https://repo.uum.edu.my/id/eprint/27991

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