Vulnerable European option pricing in a Markov regime-switching Heston model with stochastic interest rate

This paper considers pricing of European-style vulnerable options under the Heston stochastic volatility and stochastic interest rate model in which the mean-reversion levels of both variance and interest rate processes are modulated by a continuous-time Markov process with a finite state space. An analytical pricing formula is derived by using the Esscher transform, joint characteristic function and multivariate Fourier transform technique, where the closed-form solution of the characteristic function is obtained by the law of iterated expectation. Then we provide the efficient approximation to calculate the analytical pricing formula of option using the FFT approach and examine the accuracy of the approximation by Monte Carlo simulation. Finally, the sensitivity analysis of different parameters in the proposed model on the vulnerable call option price and its Delta value are provided, and the difference between the proposed model and the Heston and stochastic interest rate model with non-Markov regime-switching are presented by some numerical experiments, which shows the influence of introducing regime-switching into Heston model with stochastic interest rate.(c) 2022 Elsevier Ltd. All rights reserved.