Pricing foreign exchange options under a hybrid Heston-Cox-Ingersoll-Ross model with regime switching

Abstract

Abstract In this paper, the pricing of foreign exchange options is considered under a modified Heston–Cox–Ingersoll–Ross hybrid model. This modified model reserves all the characteristics of the Heston–Cox–Ingersoll–Ross model and also additionally assumes regime switching in the key parameters of the volatility as well as the domestic and foreign interest rates. Even though complicated, we have derived a closed-form pricing formula for foreign exchange options after the affinity of this new model is verified. Various properties of the newly derived formula are also shown through numerical experiments. To show the performance of this newly proposed model, an empirical study is also conducted, the result of which suggests that our model is a good alternative to the Heston–Cox–Ingersoll–Ross model for practical purpose.