Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model
This paper develops an analytical pricing formula for vulnerable options with stochastic volatility under a two-factor stochastic interest rate model. We consider the underlying asset price following the Heston stochastic volatility model, while the interest rate is modeled as the sum of two process...
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| Format: | Article |
| Language: | English |
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MDPI AG
2025-08-01
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| Series: | Mathematics |
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| Online Access: | https://www.mdpi.com/2227-7390/13/15/2515 |
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| author | Junkee Jeon Geonwoo Kim |
| author_facet | Junkee Jeon Geonwoo Kim |
| author_sort | Junkee Jeon |
| collection | DOAJ |
| description | This paper develops an analytical pricing formula for vulnerable options with stochastic volatility under a two-factor stochastic interest rate model. We consider the underlying asset price following the Heston stochastic volatility model, while the interest rate is modeled as the sum of two processes. Using the joint characteristic function approach and measure change techniques, we derive an explicit pricing formula for a vulnerable European option. We also conduct numerical experiments to examine the effects of various model parameters on option values. This study provides a more realistic framework for pricing OTC derivatives by incorporating credit risk, stochastic volatility, and stochastic interest rates simultaneously. |
| format | Article |
| id | doaj-art-7b4bbf7dc72945e19ba0df9e4d5a7012 |
| institution | Kabale University |
| issn | 2227-7390 |
| language | English |
| publishDate | 2025-08-01 |
| publisher | MDPI AG |
| record_format | Article |
| series | Mathematics |
| spelling | doaj-art-7b4bbf7dc72945e19ba0df9e4d5a70122025-08-20T04:00:49ZengMDPI AGMathematics2227-73902025-08-011315251510.3390/math13152515Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate ModelJunkee Jeon0Geonwoo Kim1Department of Applied Mathematics, Kyung Hee University, Yongin 17104, Republic of KoreaSchool of Natural Sciences, Seoul National University of Science and Technology, Seoul 01811, Republic of KoreaThis paper develops an analytical pricing formula for vulnerable options with stochastic volatility under a two-factor stochastic interest rate model. We consider the underlying asset price following the Heston stochastic volatility model, while the interest rate is modeled as the sum of two processes. Using the joint characteristic function approach and measure change techniques, we derive an explicit pricing formula for a vulnerable European option. We also conduct numerical experiments to examine the effects of various model parameters on option values. This study provides a more realistic framework for pricing OTC derivatives by incorporating credit risk, stochastic volatility, and stochastic interest rates simultaneously.https://www.mdpi.com/2227-7390/13/15/2515vulnerable optionstochastic interest ratestochastic volatilitycharacteristic function |
| spellingShingle | Junkee Jeon Geonwoo Kim Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model Mathematics vulnerable option stochastic interest rate stochastic volatility characteristic function |
| title | Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model |
| title_full | Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model |
| title_fullStr | Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model |
| title_full_unstemmed | Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model |
| title_short | Analytical Pricing Vulnerable Options with Stochastic Volatility in a Two-Factor Stochastic Interest Rate Model |
| title_sort | analytical pricing vulnerable options with stochastic volatility in a two factor stochastic interest rate model |
| topic | vulnerable option stochastic interest rate stochastic volatility characteristic function |
| url | https://www.mdpi.com/2227-7390/13/15/2515 |
| work_keys_str_mv | AT junkeejeon analyticalpricingvulnerableoptionswithstochasticvolatilityinatwofactorstochasticinterestratemodel AT geonwookim analyticalpricingvulnerableoptionswithstochasticvolatilityinatwofactorstochasticinterestratemodel |