Throwing Away a Billion Dollars: The Cost of Suboptimal Exercise Strategies in the Swaption Market

49 Pages Posted: 2 Jul 1999

See all articles by Francis A. Longstaff

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Pedro Santa-Clara

New University of Lisbon - Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Abstract

This paper studies the valuation and optimal exercise of American-style swaptions in a multi-factor string model of the term structure, and compares the results with those implied by standard single-factor term structure models. We find that single-factor models significantly undervalue American-style swaptions. Based on ISDA estimates of swaption notional amounts, the present value cost to swaptionholders of following myopic single-factor exercise strategies is on the order of several billion dollars. Even two- and three-factor term structure models undervalue American-style swaptions because of their inability to capture the correlations between adjacent points along the term structure. We study the optimal exercise strategy in the string model and show that it often requires exercising the option earlier than in a single-factor model. The results also show that single-factor models can lead to severely biased estimates of hedge ratios and risk-management statistics.

JEL Classification: G13

Suggested Citation

Longstaff, Francis A. and Schwartz, Eduardo S. and Santa-Clara, Pedro, Throwing Away a Billion Dollars: The Cost of Suboptimal Exercise Strategies in the Swaption Market. Available at SSRN: https://ssrn.com/abstract=164208 or http://dx.doi.org/10.2139/ssrn.164208

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Eduardo S. Schwartz

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Pedro Santa-Clara

New University of Lisbon - Nova School of Business and Economics ( email )

Lisbon
Portugal

HOME PAGE: http://docentes.fe.unl.pt/~psc/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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