This paper considers the pricing of discretely-sampled variance swaps under the class of equity-interest rate hybridization. Our modeling framework consists of the equity which follows the dynamics of the Heston stochastic volatility model and the stochastic interest rate driven by the Cox-Ingersoll-Ross (CIR) process with full correlation structure among the state variables. Since one limitation of hybrid models is the unavailability of analytical pricing formula of variance swaps due to the non-affinity property, we obtain an efficient semi-closed form pricing formula of variance swaps for an approximation of the hybrid model via the derivation of characteristic functions. We implement numerical experiments to evaluate the accuracy of our formula and confirm that the impact of the correlation between the underlying and interest rate is significant.
↧