Implications for Hedging of the Choice of Driving Process for One-Factor Markov-Functional Models

International Journal of Theoretical and Applied Finance, Vol.16, No.05, 2013

42 Pages Posted: 15 Dec 2011 Last revised: 19 Nov 2019

See all articles by Joanne Kennedy

Joanne Kennedy

University of Warwick - Department of Statistics

Duy Pham

University of Warwick - Department of Statistics

Date Written: December 15, 2011

Abstract

In this paper, we study the implications for hedging Bermudan swaptions of the choice of the instantaneous volatility for the driving Markov process of the one-dimensional swap Markov-functional model. We find that there is a strong evidence in favor of what we term "parametrization by time" as opposed to "parametrization by expiry". We further propose a new parametrization by time for the driving process which takes as inputs into the model the market correlations of relevant swap rates. We show that the new driving process enables a very effective vega-delta hedge with a much more stable gamma profile for the hedging portfolio compared with the existing ones.

Keywords: one-dimensional swap Markov-functional model, Bermudan swaption, correlation, hedging, vega, gamma, parametrization by time and by expiry

JEL Classification: G13

Suggested Citation

Kennedy, Joanne E. and Pham, Duy, Implications for Hedging of the Choice of Driving Process for One-Factor Markov-Functional Models (December 15, 2011). International Journal of Theoretical and Applied Finance, Vol.16, No.05, 2013. Available at SSRN: https://ssrn.com/abstract=1972932 or http://dx.doi.org/10.2139/ssrn.1972932

Joanne E. Kennedy (Contact Author)

University of Warwick - Department of Statistics ( email )

Coventry CV4 7AL
United Kingdom

Duy Pham

University of Warwick - Department of Statistics ( email )

Coventry, CV4 7AL
United Kingdom

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