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A SEMI-ANALYTICAL PRICING FORMULA FOR EUROPEAN OPTIONS UNDER THE ROUGH HESTON-CIR MODEL

Published online by Cambridge University Press:  06 March 2020

XIN-JIANG HE
Affiliation:
School of Mathematics and Applied Statistics, University of Wollongong, NSW 2522, Australia email [email protected]
SHA LIN*
Affiliation:
School of Finance, Zhejiang Gongshang University, Hangzhou, Zhejiang Province, China email [email protected]
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Abstract

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We combine the rough Heston model and the CIR (Cox–Ingersoll–Ross) interest rate together to form a rough Heston-CIR model, so that both the rough behaviour of the volatility and the stochastic nature of the interest rate can be captured. Despite the convoluted structure and non-Markovian property of this model, it still admits a semi-analytical pricing formula for European options, the implementation of which involves solving a fractional Riccati equation. The rough Heston-CIR model is more general, taking both the rough Heston model and the Heston-CIR model as special cases. The influence of rough volatility and stochastic interest rate is shown to be significant through numerical experiments.

Type
Research Article
Copyright
© 2020 Australian Mathematical Society

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