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

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