A Comparison of Single Factor Markov-Functional and Multi Factor Market Models
(A Comparison of Single Factor Markov-Functional and Multi Factor Market Models)
2005-04-03
Research Paper
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We compare single factor Markov-functional and multi factor market models for hedging performance of Bermudan swaptions. We show that hedging performance of both models is comparable, thereby supporting the claim that Bermudan swaptions can be adequately riskmanaged with single factor models. Moreover, we show that the impact of smile can be much larger than the impact of correlation. We propose a new method for calculating risk sensitivities of callable products in market models, which is a modification of the least-squares Monte Carlo method. The hedge results show that this new method enables proper functioning of market models as risk-management tools.
Keywords
- hedging
- market model
- Bermudan swaption
- Greeks for callable products
- Markov-functional model
- smile
- terminal correlation
Classifications using
Journal of Economic Literature (JEL) Classification System
- G3 : Corporate Finance and Governance
- M : Business Administration and Business Economics; Marketing; Accounting
- G13 : Contingent Pricing; Futures Pricing
Automatically Extracted Terms
- model
- market
- swaption
- correlation
- factor
- markov-functional model
- markov-functional
- terminal correlation
- market models
- bermudan
- delta
- volatility
- bermudan swaptions
- terminal
- method
- swap market model
- exercise decision method
- libor
- smile
- exercise
