Multiscale Stochastic Volatility with the Hull–White Rate of Interest

Authors


  • The authors thank the editor and an anonymous referee for very helpful remarks to improve this paper. Financial support from the National Research Foundation of Korea Grant NRF-2010-0008717 is gratefully acknowledged.

Abstract

Although interest rates fluctuate randomly, many option-pricing models do not fully take into account their stochastic nature because of their generally limited impact on option prices. However, stochastic changes in stochastic interest rates may exert a significant impact on option prices when issues of maturity, hedging, or stochastic volatility are considered. This study incorporates the term structure of a stochastic interest rate driven by a Hull–White process into a stochastic volatility model in order to assess the sensitivity of option prices to changes in interest rate. It demonstrates that a stochastic volatility model with a stochastic interest rate outperforms a model with a constant interest rate, particularly, for short time-to-maturity European options. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:819–837, 2014

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