CHINESE JOURNAL OF APPLIED PROBABILITY AND STATIST 2014, 30(6) 620-630 DOI:      ISSN: 1001-4268 CN: 31-1256

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Pricing Options under Two-Factor Markov-Modulated Stochastic Volatility Models

Fan Kun

School of Finance and Statistics, East China Normal University

Abstract��

In this paper, we investigate the valuation of European-style call
options under an extended two-factor Markov-modulated stochastic volatility model, where the
first stochastic volatility component is driven by a mean-reversion square-root process and
the second stochastic volatility component is modulated by a continuous-time, finite-state
Markov chain. The inverse Fourier transform is adopted to obtain analytical pricing formulae.
Numerical examples are given to illustrate the discretization of the pricing formulae and
the implementation of our model.

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