A closed-form pricing formula for European options under a multi-factor nonlinear stochastic volatility model with regime-switching

Abstract

In this paper, a new stochastic volatility model for pricing European call option is proposed, which introduces the regime-switching mechanism controlled by Markov chain in stochastic volatility and stochastic long-term mean. The advantage of adopting this new model is that it can deduce a colsed-form solution of European call option based on characteristic function of the underlying price, which can save a lot of time and effort when applied in the real market. The effect of introducing regime-switching into European call option pricing model is investigated through numerical experiments, and the results show that the regime-switching has a significant effect on the model. The empirical results further demonstrate that our model has some advantages over the other two models.