Abstract: In this paper, we incorporate Markov regime-switching into a two-factor stochastic volatility jump-diffusion model to enhance the pricing of power options. Furthermore, we assume that the interest rates and the jump intensities of the assets are stochastic. Under the proposed framework, first, we derive the analytical pricing formula for power options by using Fourier transform technique, Esscher transform and characteristic function. Then we provide the efficient approximation to calculate the analytical pricing formula of power options by using the FFT approach and examine the accuracy of the approximation by Monte Carlo simulation. Finally, we provide some sensitivity analysis of the model parameters to power options. Numerical examples show this model is suitable for empirical work in practice.

Key words: Power options, Markov regime-switching, Stochastic volatility, Stochastic , interest rate, Stochastic intensity