Option pricing with dynamically correlated stochastic interest rate

Abstract

In this work we review several option pricing models with stochastic interestrate and extend this model by incorporating local time dependent correlationbetween the underlying and the interest rate. We compare the dierence betweenusing a constant and a dynamic correlation by analyzing some numerical benchmarks.Furthermore, we conduct an experiment on tting the pricing model to themarket price. Our analysis shows that the option pricing within the Black-Scholesframework can not really be improved by incorporating stochastic interest rate evenwhen using a nonlinear correlation.