Analytically Pricing European Options under a New Two-Factor Heston Model with Regime Switching

Abstract

In this paper, we propose a new two-factor stochastic volatility model by introducing a regime switching factor into the Heston model. Despite the complicated model structure, we still manage to derive a closed-form pricing formula for European options, which can save us a lot of time in option pricing and model calibration. The results of our empirical study further indicate that our model is able to provide better performance over existing ones when real market data is employed, demonstrating its possible practical applications.