Choice of Interest Rate Term Structure Models for Assets and Liability Management

57 Pages Posted: 20 Oct 2008

See all articles by Zhenke Guan

Zhenke Guan

Manchester University - Business School

Bing Gan

University of Manchester - Manchester Business School

Aisha Khan

University of Manchester - Manchester Business School

Ser-Huang Poon

Alliance Manchester Business School, University of Manchester; Alan Turing Institute

Date Written: October 19, 2008

Abstract

This paper compares the pricing and hedging performance of the LMM model against two spot-rate models, namely Hull-White and Black-Karasinski, and the more recent Swap Market Model from an Asset-Liability-Management (ALM) perspective. In contrast to previous studies in the literature, our emphasis here is on ALM and we use hedging performance on Bermudan swaptions to proxy risk management outcome of long-term mortgage loans. Our tests involve calibrating the four interest rate models to European swaption prices for EURO and USD over the period February 2005 to September 2007. The calibrated models are then used to price and hedge a constant 11-year Bermudan swaption portfolio using a series of interest rate swaps and a 1-year holding-revision period. Our empirical results show that, the calibrated parameters of all four models are stable and their pricing errors are small and comparable. No single model dominates in the pricing exercise. The hedging performance of all four models is similar for the Euro market. For the USD market, the short rate models perform marginally better than SMM and LMM. The HW model is marginally better than BK model in terms of model parameter stability and smaller pricing and hedging errors.

Keywords: Asset-liability management, Hull-White, Black-Karasinski, Libor Market Model, Swap Market Model, Bermudan swaptions

JEL Classification: E43, G13, G21

Suggested Citation

Guan, Zhenke and Gan, Bing and Khan, Aisha and Poon, Ser-Huang, Choice of Interest Rate Term Structure Models for Assets and Liability Management (October 19, 2008). Available at SSRN: https://ssrn.com/abstract=1286854 or http://dx.doi.org/10.2139/ssrn.1286854

Zhenke Guan

Manchester University - Business School ( email )

Aytoun Street
Manchester, M1 3GH
United Kingdom

Bing Gan

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

Aisha Khan

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

Ser-Huang Poon (Contact Author)

Alliance Manchester Business School, University of Manchester ( email )

Alliance Manchester Business School
Booth Street West
Manchester, Manchester M15 6PB
United Kingdom
+44 161 275 4031 (Phone)
+44 161 275 4023 (Fax)

HOME PAGE: http://www.manchester.ac.uk/research/Ser-huang.poon/

Alan Turing Institute ( email )

British Library, 96 Euston Road
London, NW12DB
United Kingdom

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