Analytical formulae for variance and volatility swaps with stochastic volatility, stochastic equilibrium level and regime switching

Abstract

The CIR stochastic volatility model is modified to introduce nonlinear mean reversion, with the long-run volatility average as a random variable controlled by two parts being modeled through a Brownian motion and a Markov chain, respectively. This model still possesses an analytical formulation of the forward characteristic function, from which we establish variance swap prices as well as volatility swap ones with a nonlinear payoff in closed form. The numerical implementation of the two formulae demonstrates the significant impact of regime switching.

Keywords

• nonlinear mean reversion
• regime switching
• stochastic volatility
• analytical
• variance and volatility swaps