An FFT approach for option pricing under a regime-switching stochastic interest rate model |
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Authors: | Kun Fan Tak Kuen Siu Rongming Wang |
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Institution: | 1. School of Statistics, East China Normal University, Shanghai, China;2. Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW, Australia |
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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. |
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Keywords: | Fast Fourier transform Forward measure Regime-switching Stochastic interest rate |
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