Joining the Heston and a Three-Factor Hull-White Model: A Closed-Form Approach
Posted: 21 Jun 2014 Last revised: 28 Jan 2017
Date Written: June 20, 2014
In this article, we present an innovative hybrid model for the valuation of equity options. Our approach includes stochastic volatility according to Heston (1993) and features a stochastic interest rate that follows a three-factor short rate model based on Hull-White (1994). Our model is of affine structure, allows for correlations between the stock, the short rate and the volatility processes and can be fitted perfectly to the initial term structure. We determine the zero bond price formula and derive the analytic solution for European type options in terms of characteristic functions needed for fast calibration. We highlight the flexibility of our approach, by comparing the price and implied volatility surfaces of our model with the Heston model, where we in particular focus on the correlation structure. Our approach forms a comprehensive market model with an intuitive correlation structure that connects both the equity and interest market to the market volatility.
Keywords: Option valuation, Heston model, two-factor Hull-White model, Stochastic volatility, Stochastic interest rate, Analytic solution
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