Multiscale Stochastic Volatility with the Hull–White Rate of Interest

Abstract

AbstractAlthough interest rates fluctuate randomly, many option‐pricing models do not fully take into account their stochastic nature because of their generally limited impact on option prices. However, stochastic changes in stochastic interest rates may exert a significant impact on option prices when issues of maturity, hedging, or stochastic volatility are considered. This study incorporates the term structure of a stochastic interest rate driven by a Hull–White process into a stochastic volatility model in order to assess the sensitivity of option prices to changes in interest rate. It demonstrates that a stochastic volatility model with a stochastic interest rate outperforms a model with a constant interest rate, particularly, for short time‐to‐maturity European options. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:819–837, 2014