Variance swaps under L\'{e}vy process with stochastic volatility and stochastic interest rate in incomplete markets

TL;DR

This paper develops a model for pricing variance swaps in incomplete markets with stochastic volatility, stochastic interest rates, and jumps, providing closed-form solutions and numerical insights into how these factors influence swap values.

Contribution

It introduces a novel approach to pricing variance swaps considering Lévy jumps, stochastic interest rates, and stochastic volatility within an incomplete market framework, deriving closed-form solutions.

Findings

Variance swap prices depend on stochastic interest rates.

Presence of jumps increases variance swap values.

Closed-form solutions facilitate practical pricing.

Abstract

This paper focuses on the pricing of the variance swap in an incomplete market where the stochastic interest rate and the price of the stock are respectively driven by Cox-Ingersoll-Ross model and Heston model with simultaneous L\'{e}vy jumps. By using the equilibrium framework, we obtain the pricing kernel and the equivalent martingale measure. Moreover, under the forward measure instead of the risk neural measure, we give the closed-form solution for the fair delivery price of the discretely sampled variance swap by employing the joint moment generating function of the underlying processes. Finally, we provide some numerical examples to depict that the values of variance swaps not only depend on the stochastic interest rates but also increase in the presence of jump risks.