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A closed-form pricing formula for European options under a new three-factor stochastic volatility model with regime switching

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Abstract

In this paper, a new stochastic volatility model is proposed for European option pricing with the long-term mean divided into two parts; one is controlled by a stochastic process, while another is governed by a Markov chain to incorporate the regime-switching mechanics. The advantage of adopting this new model is that there exists a closed-form solution for European option prices based on the characteristic function of the underlying price, which could save a lot of effort when it is applied in real markets. The influence of introducing regime switching into option pricing models is particularly studied with numerical experiments, and results show that the regime switching could cause quite a big difference.

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Funding

This work is supported by the National Natural Science Foundation of China (No. 12101554), the Fundamental Research Funds for Zhejiang Provincial Universities (No. GB202103001), Zhejiang Provincial Natural Science Foundation of China (No. LQ22A010010) and A Project Supported by Scientific Research Fund of Zhejiang Provincial Education Department (No. Y202147703).

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Authors and Affiliations

  1. School of Economics, Zhejiang University of Technology, Hangzhou, China

    Xin-Jiang He

  2. School of Finance, Zhejiang Gongshang University, Hangzhou, China

    Sha Lin

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  1. Xin-Jiang He
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  2. Sha Lin
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Contributions

X.-J.H.: Conceptualization, methodology, software, writing-reviewing and editing. S.L.: Investigation, software, validation, writing-original draft preparation.

Corresponding author

Correspondence to Sha Lin.

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The authors have no relevant financial or non-financial interests to disclose.

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He, XJ., Lin, S. A closed-form pricing formula for European options under a new three-factor stochastic volatility model with regime switching. Japan J. Indust. Appl. Math. 40, 525–536 (2023). https://doi.org/10.1007/s13160-022-00538-7

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  • DOI: https://doi.org/10.1007/s13160-022-00538-7

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