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The Corresponding Author: RBC Financial Group Professor of Finance, Haskayne School of
Business, University of Calgary, Calgary, Alberta, Canada, T2N 1N4; Email: relliott@ucalgary.ca;
Fax: 403-770-8104; Tel: 403-220-5540
t
:= (t, X
t
) =< , X
t
> , (2.5)
where := (
1
,
2
, . . . ,
N
) with
i
R, for each i = 1, 2, . . . , N.
Let {
t
}
tT
denote the long-term volatility level. We assume that
t
depends on
the state of the economic indicator X and is given by:
t
:= (t, X
t
) =< , X
t
> , (2.6)
where := (
1
,
2
, . . . ,
N
) with
i
> 0, for each i = 1, 2, . . . , N.
Let and denote the speed of mean reversion and the volatility of volatility,
respectively. (In general, we could consider a more general case where both the
speed of mean reversion and the volatility of volatility depend on the states of
the economic indicator X.) However, in order to make our model more analytically
tractable, we suppose that both are constant. Suppose that the dynamics of the price
10
process {S
t
}
tT
and the short-term volatility process := {
t
}
tT
of the risky stock
are governed by the following equations:
dS
t
=
t
S
t
dt +
t
S
t
dW
1
t
,
d
2
t
= (
2
t
2
t
)dt +
t
dW
2
t
, (2.7)
where Cov(dW
1
t
, dW
2
t
) = dt.
Note that the variance process
2
t
follows a Cox, Ingersoll and Ross (1985) process.
Let :=
1 ; Write W := {W
t
}
tT
for a standard Brownian motion, which
is independent of W
1
and X. Then, we can write the dynamics of {S
t
}
tT
and := {
t
}
tT
as:
dS
t
=
t
S
t
dt +
t
S
t
dW
1
t
,
d
2
t
= (
2
t
2
t
)dt +
t
dW
1
t
+
t
dW
t
. (2.8)
Let Y
t
denote the logarithmic return ln(S
t
/S
0
) over the interval [0, t]. Then,
Y
t
=
_
t
0
_
1
2
2
u
_
du +
_
t
0
u
dW
1
u
. (2.9)
In our model, there are three sources of randomness: X, W
1
and W
2
. Let F
X
:=
{F
X
t
}
tT
, F
W
1
:= {F
W
1
t
}
tT
and F
W
2
:= {F
W
2
t
}
tT
be the P-augmentation of the
natural ltrations generated by {X
t
}
tT
, {W
1
t
}
tT
and {W
2
t
}
tT
, respectively. Let
11
F
S
:= {F
S
t
}
tT
denote the P-augmentation of the natural ltration generated by
{S
t
}
tT
.
Our model is a regime switching version of Hestons stochastic volatility model
and is in general incomplete. There are, therefore, innitely many equivalent martin-
gale pricing measures. In the sequel, we shall adopt the regime-switching Esscher
transform developed in Elliott et al. (2005) to determine an equivalent martin-
gale pricing measure for the volatility and variance swaps. The regime-switching
Esscher transform provides market practitioners with a convenient and
exible way to determine an equivalent martingale measure in the incom-
plete market. The choice of the equivalent martingale measure can be
justied by the regime-switching minimal entrophy equivalent martingale
(MEMM) measure (See Elliott et al. (2005)). One drawback of using the
Esscher transform is that the pricing rule by the Esscher transform is not
linear, which is considered by nancial economists as a desirable property
for a pricing rule. There are other possible approaches for determining an
equivalent martingale measure in an incomplete market, for instance, the
minimum variance hedging in Due and Richardson (1991) and Schweizer
(1992). In the minimum-variance hedging, the instrinsic value process
corresponding to a given contingent claim is used as the optimal tracking
12
process. The instrinsic value process is dened by the minimal martingale
measure introduced in Follmer and Schweizer (1991) and Schweizer (1991)
and corresponds to the risk-neutral approach for valuing the claim. The
minimum-variance hedging can provide a pertinent solution to address
the pricing and hedging of a contingent claim while the Esscher transform
mainly deals with the valuation of the claim. The hedging strategies are
optimal in sense of minimizing the expected quadratic costs. The Esscher
transform can provide a convenient and intuitive way to price a claim.
Let G
t
denote the right continuous completion of the -algebra F
X
t
F
W
1
t
F
W
2
t
,
for each t T . Let
t
:= (t, X
t
,
t
) denote a regime switching Esscher process,
which is written as follows:
t
= (t, X
t
,
t
) =< (t,
t
), X
t
> , (2.10)
where (t,
t
) := ((t,
t
, e
1
), (t,
t
, e
2
), . . . , (t,
t
, e
N
)) and (t,
t
, e
i
) is F
W
2
t
measurable, for each i = 1, 2, . . . , N. So, (t, X
t
,
t
) is an N-dimensional F
X
t
F
W
2
t
-
measurable random vector.
Following Elliott et al. (2005), for such a process we dene the regime switching
Esscher transform Q
P on G
t
with respect to a family of parameters {
u
}
u[0,t]
13
by:
dQ
dP
G
t
=
exp
_
_
t
0
u
dY
u
_
E
P
_
exp
_
_
t
0
u
dY
u
_
F
X
t
F
W
2
t
_ , t T . (2.11)
Note that
_
t
0
u
dY
u
|F
X
t
F
W
2
t
N(
_
t
0
u
(
u
1
2
2
u
)du,
_
t
0
2
u
2
u
du), that is a normal
distribution with mean
_
t
0
u
(
u
1
2
2
u
)du and variance
_
t
0
2
u
2
u
du, under P. Then
given F
X
t
F
W
2
t
, the Radon-Nikodym derivative of the regime switching Esscher
transform is given by:
dQ
dP
G
t
= exp
_
_
t
0
u
dW
1
u
1
2
_
t
0
2
u
2
u
du
_
. (2.12)
The central tenet of the fundamental theorem of asset pricing, which is also called
the fundamental theorem of nance in Ross (2005), established the equivalence be-
tween the absence of arbitrage opportunities and the existence of a positive linear
pricing operator (or positive state space prices). It was rst established by Ross
(1973) in a nite state space setting. Cox and Ross (1976) provided the rst state-
ment of risk-neutral pricing. Ross (1978) and Harrsion and Kreps (1979) then ex-
tended the fundamental theorem in a general probability space and characterized the
risk-neutral pricing as the expectation of the discounted assets payo with respect
to an equivalent martingale measure. Harrison and Kreps (1979), and Harrison and
Pliska (1981, 1983) established the equivalence between the absence of arbitrage and
the existence of an equivalent martingale measure under which all discounted price
14
processes are martingale. The fundamental theorem was then extended by several
authors, including Dybvig and Ross (1987), Back and Pliska (1991), Schachermayer
(1992) and Delbaen and Schachermayer (1994). In our setting, let
:= {
t
}
tT
denote a process for the risk-neutral regime switching Esscher parameters. Due to
the presence of the uncertainty generated the processes X and W
2
, the martingale
condition is characterised by considering an enlarged ltration and requiring:
S
0
= E
Q
_
exp
_
_
t
0
r
s
ds
_
S
t
F
X
t
F
W
2
t
_
, for any t T . (2.13)
One can interpret this condition as one when information about the Markov chain
and the stochastic volatility process are known to the markets agent in advance.
Give these arguments which are similar to those in Elliott et al. (2005), it can be
shown that the martingale condition (2.11) implies that
t
:=
(t, X
t
,
t
) should be
given by
t
=
r(t, X
t
) (t, X
t
)
2
t
=
(t, X
t
,
t
)
t
, t T , (2.14)
where
t
:= (t, X
t
,
t
) G
t
is the market price of risk at time t.
Then
t
=<
(t,
t
), X
t
>, where
(t,
t
) = (
r
1
t
,
r
2
t
, . . . ,
r
N
t
). This is an
N-dimensional F
W
2
t
-measurable random vector.
15
Using (2.12), the Radon-Nikodym derivative of Q
dP
G
t
= exp
_
_
t
0
_
r
u
u
_
dW
1
u
1
2
_
t
0
_
r
u
u
_
2
du
_
. (2.15)
By Girsanovs theorem,
W
1
t
= W
1
t
+
_
t
0
(
r
s
s
)ds is a standard Brownian motion with
respect to {G
t
}
tT
under Q
. Let
2
t
:=
2
t
(r
t
t
).
Then, the dynamics of S and under Q
are
dS
t
= r
t
S
t
dt +
t
S
t
d
W
1
t
,
d
2
t
= (
2
t
2
t
)dt +
t
d
W
1
t
+
t
dW
t
. (2.16)
Let
W
2
t
:=
W
1
t
+ W
t
. Then, the dynamics of can be written as:
d
2
t
= (
2
t
2
t
)dt +
t
d
W
2
t
. (2.17)
When there is no regime switching, (i.e. the Markov chain X is degenerate), the
risk-neutral dynamics under Q
2
R
(S) :=
1
T
_
T
0
2
u
du . (3.1)
In practice, variance swaps are written on the realized variance evaluated
based on daily closing prices with the integral in (3.1) replaced by a dis-
crete sum. Hence, variance swaps with payos depending on the realized
variance dened in (3.1) are only approximations to those of the actual
contracts. See Javaheri et al. (2002) for discussions on this point.
Let K
v
and N denote the delivery price for variance and the notional amount
of the swap in dollars per annualized volatility point squared. Then, the payo of
the variance swap at expiration time T is given by N(
2
R
(S) K
v
). Intuitively, the
buyer of the variance swap will receive N dollars for each point by which the realized
annual variance
2
R
(S) has exceeded the variance delivery price K
v
. We can adopt the
17
risk-neutral regime switching Esscher transform Q
[e
R
T
0
r
u
du
N(
2
R
(S) K
v
)|F
X
T
]
= e
R
T
0
r
u
du
NE
Q
(
2
R
(S)|F
X
T
) e
R
T
0
r
u
du
NK
v
. (3.2)
Hence, the valuation of the variance swap given F
X
T
can be reduced to the problem
of calculating the mean value of the underlying variance E
Q
(
2
R
(S)|F
X
T
).
Note that under Q
2
t
=
2
0
+
_
t
0
(
2
s
2
s
)ds +
_
t
0
s
d
W
2
s
. (3.3)
Given F
X
T
,
2
t
is a known function of time t. Hence,
E
Q
(
2
t
|F
X
T
) =
2
0
+
_
t
0
[
2
s
E
Q
(
2
s
|F
X
T
)]ds . (3.4)
18
This implies that
dE
Q
(
2
t
|F
X
T
)
dt
= [
2
t
E
Q
(
2
t
|F
X
T
)] . (3.5)
Solving (3.5) gives:
E
Q
(
2
t
|F
X
T
) =
2
0
e
t
+
_
t
0
2
s
e
(ts)
ds . (3.6)
By Itos lemma,
4
t
=
4
0
+
_
t
0
[2
2
s
(
2
s
2
s
) +
2
2
s
]ds +
_
t
0
2
3
s
d
W
2
s
. (3.7)
Hence,
dE
Q
(
4
t
|F
X
T
)
dt
= (2
2
t
+
2
)E
Q
(
2
t
|F
X
T
) 2E
Q
(
4
t
|F
X
T
) . (3.8)
Solving (3.8) gives:
E
Q
(
4
t
|F
X
T
) =
4
0
e
2t
+
_
t
0
e
2(ts)
(2
2
s
+
2
)
_
2
0
e
s
+
_
s
0
2
u
e
(su)
du
_
ds . (3.9)
Hence,
V ar
Q
(
2
t
|F
X
T
)
= E
Q
(
4
t
|F
X
T
) E
2
Q
(
2
t
|F
X
T
)
=
2
0
(e
t
e
2t
) +
_
t
0
_
e
2(ts)
_
2
2
2
s
+
2
_
_
s
0
2
u
e
(su)
du
_
ds
2
_
_
t
0
2
s
e
(ts)
ds
_
2
. (3.10)
19
The results for E
Q
(
2
t
|F
X
T
) and V ar
Q
(
2
t
|F
X
T
) are consistent with those in Shreve
(2004).
Write V :=
2
R
(S) to simplify the notation. Then, E
Q
(V |F
X
T
) can be calculated
as follows:
E
Q
(V |F
X
T
) =
1
T
_
T
0
_
2
0
e
t
+
_
t
0
2
s
e
(ts)
ds
_
dt
=
2
0
T
(1 e
T
) +
T
_
T
0
_
_
t
0
2
s
e
(ts)
ds
_
dt , (3.11)
We evaluate V ar
Q
(V |F
X
T
) as follows:
V ar
Q
(V |F
X
T
)
= Cov
Q
(V, V |F
X
T
)
= 1/T
2
_
T
0
_
T
0
Cov
Q
(
2
t
,
2
s
|F
X
T
)dtds (3.12)
We rst derive an expression for Cov
Q
(
2
t
,
2
s
|F
X
T
). Without loss of generality, we
suppose that t > s. Then, we dene
t,s
as follows:
t,s
:=
2
t
E
Q
(
2
t
|F
W
2
s
F
X
T
)
=
2
t
2
s
e
(ts)
_
t
s
2
u
e
(tu)
du . (3.13)
Then, it is immediate that
E
Q
(
t,s
|F
W
2
s
F
X
T
) = 0 , (3.14)
20
E
Q
(
t,s
2
s
|F
X
T
) = 0 , (3.15)
so
Cov
Q
(
t,s
,
2
s
|F
X
T
) = 0 . (3.16)
Hence,
Cov
Q
(
2
t
,
2
s
|F
X
T
)
= Cov
Q
(
t,s
+
2
s
e
(ts)
+
_
t
s
2
u
e
(tu)
,
2
s
|F
X
T
)
= e
(ts)
V ar
Q
(
2
s
|F
X
T
)
= e
(ts)
_
2
0
(e
s
e
2s
) +
_
s
0
_
e
2(su)
_
2
2
2
u
+
2
_
_
u
0
2
z
e
(uz)
dz
_
du
2
_
_
s
0
2
u
e
(su)
du
_
2
_
. (3.17)
Therefore,
V ar
Q
(V |F
X
T
)
= 1/T
2
_
T
0
_
T
0
e
(ts)
_
2
0
(e
s
e
2s
) +
_
s
0
_
e
2(su)
_
2
2
2
u
+
2
_
_
u
0
2
z
e
(uz)
dz
_
du
2
_
_
s
0
2
u
e
(su)
du
_
2
_
dtds
=
2
0
2
T
2
_
(1 e
T
)T +
1
4
(1 e
2T
)
2
_
+ 1/T
2
_
T
0
_
T
0
e
(ts)
_
_
s
0
_
e
2(su)
_
2
2
2
u
+
2
_
_
u
0
2
z
e
(uz)
dz
_
du
2
_
_
s
0
2
u
e
(su)
du
_
2
_
dtds . (3.18)
For each i = 1, 2, . . . , N, let
i
:=
i
(r
i
i
); Write := (
1
,
2
, . . . ,
N
). Given
21
F
X
T
, the conditional price of the variance swap is given by:
P(X) = e
R
T
0
r
u
du
N
_
2
0
T
(1 e
T
) +
T
_
T
0
_
_
t
0
<
2
, X
t
> e
(ts)
ds
_
dt K
v
_
. (3.19)
Consider now the valuation of the volatility swap given F
X
T
. A stock volatility
swap is a forward contract on the annualized volatility. Let K
s
denote the annualized
volatility delivery price and N is the notational amount of the swap in dollar per
annualized volatility point. Then, the payo function of the volatility swap is given
by N(
R
(S) K
s
), where
R
(S) :=
_
1
T
_
T
0
2
u
du. In other words, the payo of the
volatility swap is equal to the payo of the variance swap when
2
R
(S) is replaced by
R
(S) and K
v
is replaced by K
s
. Given F
X
T
, the conditional price of the volatility
swap is given by:
P
s
(X) = E
Q
[e
R
T
0
r
u
du
N(
R
(S) K
s
)|F
X
T
]
= e
R
T
0
r
u
du
NE
Q
(
R
(S)|F
X
T
) e
R
T
0
r
u
du
NK
s
= e
R
T
0
r
u
du
NE
Q
V |F
X
T
) e
R
T
0
r
u
du
NK
s
. (3.20)
For the valuation of the volatility swap, we need to evaluate E
Q
V |F
X
T
). We
adopt the approximation for E
Q
V |F
X
T
) introduced by Brockhaus and Long (2000),
based on the second-order Taylor expansion for the function
V . This approxima-
tion method has also been adopted in Javaheri et al. (2002) and Swishchuk (2004).
22
It gives
E
Q
V |F
X
T
)
_
E
Q
(V |F
X
T
)
V ar
Q
(V |F
X
T
)
8[E
Q
(V |F
X
T
)]
3/2
, (3.21)
where the term
V ar
Q
(V |F
X
T
)
8[E
Q
(V |F
X
T
)]
3/2
is the convexity adjustment.
Hence, given F
X
T
, the conditional price of the volatility swap can be approximated
as:
P
s
(X) e
R
T
0
r
u
du
N
__
E
Q
(V |F
X
T
)
V ar
Q
(V |F
X
T
)
8[E
Q
(V |F
X
T
)]
3/2
K
s
_
. (3.22)
23
3.2. Hedging
Hedging variance swaps and volatility swaps is a challenging but practically im-
portant task. Javaheri et al. (2002) contended that hedging these products is dicult
in practice. Hence, they considered the pricing of a variance swap and a volatility
swap by the expectations of the discounted payos under the real-world probability
measure. This is an example of actuarial-based valuation method. In this section, we
shall discuss the hedging of variance swaps and volatility swaps. Dierent methods on
hedging variance swaps, have been proposed in the literature. These methods include
the simple delta hedging, the delta-gamma hedging, hedging using option portfolios,
hedging using a log contract and the vega hedging, etc. For a comprehensive overview
of various hedging strategies, see Demeter et al. (1999), Howison et al. (2004) and
Windcli et al. (2003). Simple delta hedging does not work well since it is an implicit
linear approximation, which cannot incorporate the eects of large price movements
and the realized variance or volatility will increase substantially when the underlying
share prices move either up or down dramatically. This is the case even one considers
a Geometric Brownian Motion for the price dynamics of the underlying share. Simple
delta hedging is even more dicult to apply when one considers a stochastic volatility
model and a regime-switching stochastic volatility model, which is even more com-
plicated. Hedging using option portfolios and hedging using a log contract works
24
well when one considers an asset price model with non-stochastic volatility. The vega
hedging provides market practitioners with a convenient way to hedge variance swaps
and volatility swaps under a stochastic volatility model, in particular, the Heston SV
model (see Howison et al. (2004) and Carr (2005)). Howison et al. (2004) considered
the use of Vega to hedge volatililty derivatives and derived a general formula for the
Vega of a volatility derivative. Here, following Howison et al. (2004), we adopt the
Vega hedging for a variance swap and a volatility swap since it can provide a conve-
nient way to hedge these products under the regime-switching Hestons SV model. In
the case of the volatility swap, we shall derive an approximate formula for the Vega
of the contract based on the approximate price of the contract.
First, we consider the hedging of the variance swap. Let I
t
:=
_
t
0
2
u
du. Write
F
W
2
t
for the P-augmentation of the -algebra generated by the values of
W
2
up to
and including time t. Note that given F
X
T
, F
W
2
t
is equivalent to F
W
2
t
. Then, using
the results in Section 3.1, the price of the variance swap P(t, X) at time t is given
by:
P(t, X) =
1
T
e
R
T
t
r
u
du
N
_
I
t
+E
Q
_
_
T
t
2
u
du
F
X
T
F
W
2
t
_
TK
v
_
=
1
T
e
R
T
t
r
u
du
N
_
I
t
+
2
t
(e
t
e
T
) +
_
T
t
_
_
s
t
<
2
, X
u
>
e
(su)
du
_
ds TK
v
_
. (3.23)
25
Let
2
t
:=
2
t
, which represents the instantaneous volatility of the variance process
at time t. Then, the Vega of the variance swap is given by:
P(t, X)
=
2N
t
T
2
(e
t
e
T
)
=
2N
t
T
(e
t
e
T
) , (3.24)
which can be evaluated given the current value of the volatility level
t
.
We shall consider the hedging of the volatility swap. First, we dene R
1
(t,
2
t
),
R
2
(t,
2
t
) and R
3
(t,
2
t
) as follows:
R
1
(t,
2
t
) = I
t
+
2
t
(e
t
e
T
) +
_
T
t
_
_
s
t
<
2
, X
u
> e
(su)
du
_
ds ,
R
2
(t,
2
t
) =
2
t
2
T
2
3
[e
(Tt)
2
e
2(Tt)
] +
1
T
2
_
T
t
_
T
t
_
e
(hs)
_
s
0
_
e
2(su)
_
2
2
2
u
+
2
_
_
u
0
2
z
e
(uz)
dz
_
du
2
_
_
s
0
2
u
e
(su)
du
_
2
_
dhds ,
and
R
3
(t,
2
t
) =
2
t
2
T
2
_
(1 e
t
)t +
1
4
(1 e
2t
)
2
_
+ 1/T
2
_
t
0
_
t
0
_
e
(us)
_
s
0
_
e
2(su)
_
2
2
2
u
+
2
_
_
u
0
2
z
e
(uz)
dz
_
du
2
_
_
s
0
2
u
e
(su)
du
_
2
_
duds .
26
From the results in Section 3.1, the price of the volatility swap P
s
(t, X) at time t can
be approximated as:
P
s
(t, X) e
R
T
t
r
u
du
N
__
E
Q
(V |F
X
T
F
W
2
t
)
V ar
Q
(V |F
X
T
F
W
2
t
)
8[E
Q
(V |F
X
T
F
W
2
t
)]
3/2
K
s
_
= e
R
T
t
r
u
du
N
_
_
R
1
(t,
2
t
)
R
3
(t,
2
t
) +R
2
(t,
2
t
)
8R
1
(t,
2
t
)
3/2
K
s
_
. (3.25)
Write R
i
for R
i
(t,
2
t
) (i = 1, 2, 3). Then, the Vega of the volatility swap is approxi-
mated as:
P
s
(t, X)
= e
R
T
t
r
u
du
N
_
R
1
1/2
(e
t
e
T
) +
3
t
8
(R
3
+R
2
)R
1
5/2
(e
t
+e
T
) +
t
2
R
1
4T
2
3
_
e
(Tt)
2
+
1
e
2(Tt)
__
, (3.26)
which can be evaluated given the current value of the volatility level
t
.
4. The P.D.E. Approach
In this section, we adopt a partial dierential equation (P.D.E.) approach for
evaluating the expectations of the discounted values of V and V
2
, which are useful
for computing the prices of the variance swaps and volatility swaps. The P.D.E.
approach has been adopted by Javaheri, et al. (2002) for the valuation and hedging of
volatility swaps within the framework of a GARCH(1, 1) stochastic volatility model.
Here, we provide a regime switching modication of the problem and derive regime
switching P.D.E.s and the corresponding systems of coupled P.D.E.s satised by the
27
expectations of the discounted values of V and V
2
. We adopt a regime switching
version of the Feyman-Kac formula to obtain the regime switching P.D.Es. The
derivation of the regime switching version of the Feyman-Kac formula follows from
the martingale approach and Itos dierentiation rule in Bungton and Elliott (2002).
First, let V
t
:=
2
R,t
(S) :=
1
T
_
t
0
2
u
du. Then, given F
W
2
t
F
X
T
, the price of the
variance swap is given by:
P(X, t) = e
R
T
t
r
u
du
NE
Q
(
2
R,T
(S)|F
W
2
t
F
X
T
) e
R
T
t
r
u
du
NK
v
, (4.1)
and the price of the volatility swap is given by:
P
s
(X, t)
= e
R
T
t
r
u
du
NE
Q
(
R,T
(S)|F
W
2
t
F
X
T
) e
R
T
t
r
u
du
NK
s
. (4.2)
Now, suppose
2
t
= , X
t
= X and V
t
= V are given at time t. Then, the price of
the variance swap is given by:
P(X, , V, t) = E
Q
(P(X, t)|
2
t
= , V
t
= V, X
t
= X) , (4.3)
and the price of the volatility swap is given by:
P
s
(X, , V, t) = E
Q
(P
s
(X, t)|
2
t
= , V
t
= V, X
t
= X) . (4.4)
Bungton and Elliott (2002a, b) adopted a similar method to determine the price of
a standard European call option.
28
By the double expectation formula,
P(X, , V, t)
= NE
Q
_
e
R
T
t
r
u
du
2
R,T
(S) e
R
T
t
r
u
du
K
v
t
= , V
t
= V, X
t
= X
_
, (4.5)
and
P
s
(X, , V, t)
= NE
Q
_
e
R
T
t
r
u
du
R,T
(S) e
R
T
t
r
u
du
K
s
2
t
= , V
t
= V, X
t
= X
_
. (4.6)
Hence, for the evaluation of P(X, , V, t) and P
s
(X, , V, t), we need to compute
1. E
Q
_
e
R
T
t
r
u
du
2
t
= , V
t
= V, X
t
= X
_
2. E
Q
_
e
R
T
t
r
u
du
2
R,T
(S)
2
t
= , V
t
= V, X
t
= X
_
3. E
Q
_
e
R
T
t
r
u
du
R,T
(S)
2
t
= , V
t
= V, X
t
= X
_
The rst expectation is equal to the value of a zero-coupon bond at time t given that
2
t
= , V
t
= V, X
t
= X, which pays one unit of account at maturity time T. It is
given by:
E
Q
_
e
R
T
t
r
u
du
2
t
= , V
t
= V, X
t
= X
_
= E
Q
_
e
R
T
t
r
u
du
X
t
= X
_
:= B(t, T, X) . (4.7)
29
Let B := diagr
_
e
R
T
t
r
u
du
R,T
(S)
2
t
= , V
t
= V, X
t
= X
_
_
E
Q
_
e
2
R
T
t
r
u
du
2
R,T
(S)
2
t
= , V
t
= V, X
t
= X
_
V ar
Q
_
e
2
R
T
t
r
u
du
2
R,T
(S)
2
t
= , V
t
= V, X
t
= X
_
8
_
E
Q
_
e
2
R
T
t
r
u
du
2
R,T
(S)
2
t
= , V
t
= V, X
t
= X
__ . (4.9)
Hence, in order to provide an approximation to the third expectation, we need to
evaluate
1. E
Q
(e
4
R
T
t
r
u
du
4
R,T
(S)|
2
t
= , V
t
= V, X
t
= X)
2. E
Q
(e
2
R
T
t
r
u
du
2
R,T
(S)|
2
t
= , V
t
= V, X
t
= X).
Suppose H
t
:= {W
2
u
, X
u
|u [0, t]}. Since V
t
is a path integral of
2
t
and
2
t
is a Markov process given knowledge of X, (V
t
,
2
t
) is a two-dimensional Markov
30
process given the knowledge of X. Since X is also a Markov process, (X
t
,
2
t
, V
t
) is a
three-dimensional Markov process with respect to the information set H
t
. Hence,
M
1
(X, , V, t) := E
Q
(e
R
T
t
r
u
du
2
R,T
(S)|
2
t
= , V
t
= V, X
t
= X)
= E
Q
(e
R
T
t
r
u
du
2
R,T
(S)|H
t
) , (4.10)
M
2
(X, , V, t) := E
Q
(e
2
R
T
t
r
u
du
2
R,T
(S)|
2
t
= , V
t
= V, X
t
= X)
= E
Q
(e
2
R
T
t
r
u
du
2
R,T
(S)|H
t
) , (4.11)
and
M
3
(X, , V, t) := E
Q
(e
4
R
T
t
r
u
du
4
R,T
(S)|
2
t
= , V
t
= V, X
t
= X)
= E
Q
(e
4
R
T
t
r
u
du
4
R,T
(S)|H
t
) , (4.12)
Now, write
M
1
(X, , V, t) := e
R
t
0
r
u
du
M
1
(X, , V, t)
= E
Q
(e
R
T
0
r
u
du
2
R,T
(S)|H
t
) , (4.13)
M
2
(X, , V, t) := e
2
R
t
0
r
u
du
M
2
(X, , V, t)
= E
Q
(e
2
R
T
0
r
u
du
2
R,T
(S)|H
t
) , (4.14)
and
M
3
(X, , V, t) := e
4
R
t
0
r
u
du
M
3
(X, , V, t)
31
= E
Q
(e
4
R
T
0
r
u
du
4
R,T
(S)|H
t
) . (4.15)
Then, it can be shown that
M
1
,
M
2
and
M
3
are H
t
-martingales under Q
.
In the sequel, we shall derive the P.D.E. for
M
1
,
M
2
and
M
3
. For each i = 1, 2, 3,
let
M
i
(, V, t) denote the N-dimensional vector (
M
i
(e
1
, , V, t), . . . ,
M
i
(e
N
, , V, t)).
Then,
M
i
(X, , V, t) =<
M
i
(, V, t), X
t
> . (4.16)
Then, by applying Itos dierentiation rule to
M
i
(X, , V, t),
M
i
(X, , V, t) =
M
i
(X, , V, 0) +
_
t
0
_
M
i
u
+(
2
u
2
u
)
M
i
+
1
2
2
u
2
M
i
2
+
2
u
M
i
V
_
du +
_
t
0
M
i
u
d
W
2
u
+
_
t
0
<
M
i
, dX
u
> , (4.17)
and
dX
t
= (t)X
t
dt +dM
t
. (4.18)
Due to the fact that
M
1
,
M
2
and
M
3
are H
t
-martingale under Q
M
i
t
+(
2
t
2
t
)
M
i
+
1
2
2
t
2
M
i
2
+
2
t
M
i
V
+ <
M
i
, X >= 0 . (4.19)
32
Now, let M
i
(, V, t) denote the N-dimensional vector (M
i
(e
1
, , V, t), . . . , M
i
(e
N
, , V, t)),
where i = 1, 2, 3. Then,
M
i
(X, , V, t) =< M
i
(, V, t), X
t
> . (4.20)
M
1
satises the following P.D.E.:
_
exp
_
_
t
0
r
u
du
___
r
t
M
1
+
M
1
t
+(
2
t
2
t
)
M
1
+
1
2
2
t
2
M
1
2
+
2
t
M
1
V
+ < M
1
, X >
_
= 0 , (4.21)
with terminal condition M
1
(X, , V, T) = V
T
.
M
2
satises the following P.D.E.:
_
exp
_
2
_
t
0
r
u
du
___
2r
t
M
2
+
M
2
t
+(
2
t
2
t
)
M
2
+
1
2
2
t
2
M
2
2
+
2
t
M
2
V
+ < M
2
, X >
_
= 0 , (4.22)
with terminal condition M
2
(X, , V, T) = V
T
.
M
3
satises the following P.D.E.:
_
exp
_
4
_
t
0
r
u
du
___
4r
t
M
3
+
M
3
t
+(
2
t
2
t
)
M
3
+
1
2
2
t
2
M
3
2
+
2
t
M
3
V
+ < M
3
, X >
_
= 0 , (4.23)
with terminal condition M
3
(X, , V, T) = V
2
T
.
33
Note that with X = e
j
(j = 1, 2, . . . , N),
r
t
= < r, X
t
>= r
j
,
t
= < , X
t
>=
j
. (4.24)
Let M
ij
:= M
i
(e
j
, , V, T), where i = 1, 2, 3 and j = 1, 2, . . . , N. Then, M
i
=
(M
i1
, M
i2
, . . . M
iN
). Hence, M
1
satises the following system of N coupled P.D.E.s:
r
j
M
1j
+
M
1j
t
+(
2
j
2
t
)
M
1j
+
1
2
2
t
2
M
1j
2
+
2
t
M
1j
V
+ < M
1
, e
j
>= 0 , (4.25)
with terminal condition M
1
(e
j
, , V, T) = V
T
.
M
2
satises the following system of N coupled P.D.E.s:
2r
j
M
2j
+
M
2j
t
+(
2
j
2
t
)
M
2j
+
1
2
2
t
2
M
2j
2
+
2
t
M
2j
V
+ < M
2
, e
j
>= 0 , (4.26)
with terminal condition M
2
(e
j
, , V, T) = V
T
.
M
3
satises the following system of N coupled P.D.E.s:
4r
j
M
3j
+
M
3j
t
+(
2
j
2
t
)
M
3j
+
1
2
2
t
2
M
3j
2
+
2
t
M
3j
V
+ < M
3
, e
j
>= 0 , (4.27)
with terminal condition M
3
(e
j
, , V, T) = V
2
T
.
34
Once M
1
, M
2
and M
3
are solved from the above systems of N coupled P.D.E.s,
we can use them to approximate the prices of the variance swap and the volatility
swap.
5. Monte Carlo Experiment
In this section, we shall perform a Monte Carlo Experiment for the prices of the
variance swaps and the volatility swaps implied by the regime-switching Hestons
stochastic volatility model. We shall document economic consequences for the prices
of the variance swaps and the volatility swaps of a regime-switching in Hestons
stochastic volatility model by comparing the prices with those obtained from Hestons
SV model without regime-switching. We shall compute the prices of the variance
swaps and the volatility swaps with various delivery prices under both the regime-
switching Hestons SV model and Hestons SV model without switching regimes by
Monte Carlo simulation. For illustration, we suppose that the number of regimes N =
2 throughout this section. The rst and second regimes, namely X
t
= 1 and X
t
= 2,
can be interpreted as the Good and Bad economic states, respectively. We also
assume that Hestons SV model without switching regimes coincides with the rst
regime of the regime-switching Hestons SV model. In this case, we can investigate
economic consequences for the prices of the variance swaps and the volatility swaps
35
when we allow the possibility that the dynamics of Hestons SV model switches over
time to the one corresponding to the Bad economic states. We generate 10,000
simulation runs for computing each price. All computations were done by C++
codes with GSL functions.
We shall assume some specimen values for the parameters of regime-switching
Hestons SV model and the one without switching regimes. When the economy is
good (bad), the interest rate is high (low). Let r
1
and r
2
denote the annual interest
rates for the Good state and the Bad state, respectively. Then, we suppose that
r
1
= 5% and r
2
= 2%. The appreciation rate of the underlying risky asset is high
(low) when the economy is good (bad). In each case, the appreciation rate should
be higher than the corresponding interest rate. Hence, we suppose that the annual
appreciation rate
1
= 7% for the Good state and the annual appreciation rate
2
= 5% for the Bad state. When the economy is good (bad), the underlying risky
asset is less (more) volatile. Hence, we suppose that
1
= 0.12 and
2
= 0.24. The
speed of mean reversion = 0.2 and the volatility of volatility parameter = 0.08.
We also assume that the correlation coecient is negative and is equal to 0.5.
The transition probabilities of the Markov chain are
11
= 0.5,
12
= 0.5,
21
= 0.5,
22
= 0.5. The notational amount of the variance swap or the volatility swap is 1
million. We suppose that the current economic state X
0
= 1 and that the current
36
volatility level V
0
= 0.12. The delivery prices of the variance swap and the volatility
swap range from 80% to 125% of the current levels of the variance and the standard
deviation of the underlying risky asset, respectively. The time-to-expiry of both the
variance swap and the volatility swap is 1 year. Since the regime-switching Heston
stochastic volatility model is a continuous-time model, we need to discretize it when
we compute the prices of the variance swaps and volatility swaps by Monte Carlo
simulation. We suppose that the number of steps for the discretization is 20. Table
1 displays the prices of the variance swaps for various delivery prices implied by
the regime-switching Heston stochastic volatility model and its non-regime-switching
counterpart.
Table 1: Prices of Variance Swaps with and without Switching Regimes
Delivery Prices Prices with Switching Regimes Prices without Switching Regimes
in % in million in million
80 1.14556 0.847634
85 1.1431 0.845326
90 1.14165 0.843224
95 1.13823 0.840911
100 1.13607 0.838839
105 1.13167 0.836526
110 1.12934 0.834374
115 1.12657 0.832061
120 1.12196 0.829986
125 1.12082 0.82767
37
Table 2 displays the prices of the volatility swaps for various delivery prices im-
plied by the regime-switching Heston stochastic volatility model and its non-regime-
switching counterpart.
Table 2: Prices of Volatility Swaps with and without Switching Regimes
Delivery Prices Prices with Switching Regimes Prices without Switching Regimes
in % in million in million
80 0.632453 0.467974
85 0.624144 0.461601
90 0.616364 0.455246
95 0.607529 0.448786
100 0.599301 0.442436
105 0.589936 0.436079
110 0.581685 0.429701
115 0.573195 0.423343
120 0.563777 0.416992
125 0.55599 0.410641
From Table 1 and Table 2, we see that the prices of the variance swaps and the
volatility swaps implied by the regime-switching Heston stochastic volatility model
are signicantly higher than the corresponding prices of the variance swaps and the
volatility swaps, respectively, implied by the standard Heston stochastic volatility
without switching regimes. This reveals that a higher risk premium is required to
compensate for the risk from the structural change of the volatility dynamics to the
one with higher long-term volatility level due to the possible transitions of the states
38
of the economy to the Bad state. This illustrates the economic signicance of
incorporating the switching regimes in the volatility dynamics for pricing variance
swaps and volatility swaps.
6. Further Research
For further investigation, it is interesting to explore and develop some criteria to de-
termine the number of states of the Markov chain in our framework which will incor-
porate important features of the volatility dynamics for dierent types of underlying
nancial instruments, such as commodities, currencies and xed income securities. It
is also interesting to explore the applications of our model to price various volatility
derivative products, such as options on volatilities and VIX futures, which are a listed
contract on the Chicago Board Options Exchange. It is also of practical interest to
investigate the calibration and estimation techniques of our model to volatility index
options. Empirical studies comparing the performance of models on volatility swaps
are interesting topics to be investigated further.
Acknowledgment
We would like to thank the referee for many valuable comments and suggestions.
39
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