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.

Bermudan swaption, Greeks for callable products, Markov-functional model, hedging, market model, smile, terminal correlation
Contingent Pricing; Futures Pricing (jel G13), Corporate Finance and Governance (jel G3), Business Administration and Business Economics; Marketing; Accounting (jel M)
hdl.handle.net/1765/1930
ERIM Report Series Research in Management
ERIM report series research in management Erasmus Research Institute of Management
Erasmus Research Institute of Management

Pietersz, R, & Pelsser, A.A.J. (2005). A Comparison of Single Factor Markov-Functional and Multi Factor Market Models (No. ERS-2005-008-F&A). ERIM report series research in management Erasmus Research Institute of Management. Retrieved from http://hdl.handle.net/1765/1930