Pricing variance swaps under a stochastic interest rate and volatility model with regime-switching

Yang Shen, Tak Kuen Siu*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

21 Citations (Scopus)

Abstract

In this paper, we investigate the pricing of variance swaps under a Markovian regime-switching extension of the Schöbel-Zhu-Hull-White hybrid model. The parameters of this model, including the mean-reversion levels and the volatility rates of both stochastic interest rate and volatility, switch over time according to a continuous-time, finite-state, observable Markov chain. By utilizing techniques of measure changes, we separate the interest rate risk from the volatility risk. The prices of variance swaps and related fair strike values are represented in integral forms. We illustrate the practical implementation of the model by providing a numerical analysis in a two-state Markov chain case, which shows that the effect of both stochastic interest rate and regime-switching is significant in the pricing of variance swaps.

Original languageEnglish
Pages (from-to)180-187
Number of pages8
JournalOperations Research Letters
Volume41
Issue number2
DOIs
Publication statusPublished - Mar 2013

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