Valuation of correlation options under a stochastic interest rate model with regime switching

Abstract

We consider the valuation of a correlation option, a two-factor analog of a European call option, under a Hull-White interest rate model with regime switching. More specifically, the model parameters are modulated by an observable, continuous-time, finite-state Markov chain. We obtain an integral pricing formula for the correlation option by adopting the techniques of measure changes and inverse Fourier transform. Numerical analysis, via the fast Fourier transform, is provided to illustrate the practical implementation of our model.

Keywords

Correlation option / stochastic interest rate / regime-switching / forward measure / fast Fourier transform (FFT)

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