American Options in the Heston Model With Stochastic Interest Rate

Abstract

We consider the Heston model with the stochastic interest rate of the CIR type and more general models with stochastic volatility and interest rates depending on two CIR - factors. Time derivative and infinitesimal generator of the process for factors that determine the dynamics of the interest rate and/or volatility are discretized. The result is a sequence of embedded perpetual options arising in the time - discretization of a Markov - modulated Levy model. Options in this sequence are solved using an iteration method based on the Wiener - Hopf factorization. Typical shapes of the early exercise boundary are shown, and good agreement of option prices with prices calculated with the Longstaff - Schwartz method and Medvedev - Scaillet asymptotic method is demonstrated.