An extension of Heston’s SV model to stochastic interest rates

Abstract

In 'A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options', Heston proposes a Stochastic Volatility (SV) model with constant interest rate and derives a semi-explicit valuation formula. Heston also describes, in general terms, how the model could be extended to incorporate Stochastic Interest Rates (SIR). This paper is devoted to the construction of an extension of Heston's SV model with a particular stochastic bond model which, just increasing in one the number of parameters, allows to incorporate SIR and to derive a semi-explicit formula for option pricing.