An FFT approach for option pricing under a regime-switching stochastic interest rate model

Kun Fan, Yang Shen*, Tak Kuen Siu, Rongming Wang

*Corresponding author for this work

Research output: Contribution to journalArticle

6 Citations (Scopus)

Abstract

In this article, we investigate the pricing of European-style options under a Markovian regime-switching Hull–White interest rate model. The parameters of this model, including the mean-reversion level, the volatility of the stochastic interest rate, and the volatility of an asset’s value, are modulated by an observable, continuous-time, finite-state Markov chain. A closed-form expression for the characteristic function of the logarithmic terminal asset price is derived. Then, using the fast Fourier transform, a price of a European-style option is computed. In a two-state Markov chain case, numerical examples and empirical studies are presented to illustrate the practical implementation of the model.

Original languageEnglish
Pages (from-to)5292-5310
Number of pages19
JournalCommunications in Statistics - Theory and Methods
Volume46
Issue number11
DOIs
Publication statusPublished - 3 Jun 2017

Keywords

  • Fast Fourier transform
  • Forward measure
  • Regime-switching
  • Stochastic interest rate

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