A closed-form pricing formula for European options under the Heston model with stochastic interest rate

Abstract

In this paper, a closed-form pricing formula for European options in the form of an infinite series is derived under the Heston model with the interest rate being another random variable following the CIR (Cox–Ingersoll–Ross) model. One of the main advantages for the newly derived series solution is that we can provide a radius of convergence, which is complemented by some numerical experiments demonstrating its speed of convergence. To further verify our formula, option prices calculated through our formula are also compared with those obtained from Monte Carlo simulations. Finally, a set of pricing formulae are derived with the series expanded at different points so that the entire time horizon can be covered by converged solutions.