Pricing variance swaps under stochastic volatility and stochastic interest rate

Abstract

In this paper, we investigate the effects of imposing stochastic interest rate driven by the Cox–Ingersoll–Ross process along with the Heston stochastic volatility model for pricing variance swaps with discrete sampling times. A dimension reduction mechanism based on the framework of Little and Pant (2001) is applied which later reduces to solving two three-dimensional partial differential equations. A semi-closed form solution to the fair delivery price of a variance swap is obtained via the derivation of characteristic functions. Practical implementation of this hybrid model is demonstrated through numerical simulations.