Pricing variance swaps under stochastic volatility and stochastic interest rate
Date
2016
Authors
Cao, J.
Lian, G.
Roslan, T.R.N.
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Journal article
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Applied Mathematics and Computation, 2016; 277:72-81
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Abstract
In this paper, we investigate the effects of imposing stochastic interest rate driven by the Cox-Ingersoll-Ross process along with the Heston stochastic volatility model for pricing variance swaps with discrete sampling times. A dimension reduction mechanism based on the framework of Little and Pant (2001) is applied which later reduces to solving two three-dimensional partial differential equations. A semi-closed form solution to the fair delivery price of a variance swap is obtained via the derivation of characteristic functions. Practical implementation of this hybrid model is demonstrated through numerical simulations.
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Copyright 2016 Published by Elsevier