On Pricing and Hedging in the Swaption Market: How Many Factors, Really?

41 Pages Posted: 3 Oct 2001

See all articles by Rong Fan

Rong Fan

Gifford Fong Associates

Anurag Gupta

Case Western Reserve University - Department of Banking & Finance

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Date Written: July 3, 2007

Abstract

This article examines how the number of stochastic drivers and their associated volatility structures affect pricing accuracy and hedging performance in the swaption market. In spite of the fact that low dimensional one and two-factor models do not reflect historical correlations that exist among forward rates, we show that they are capable of accurately pricing swaptions as well as higher order multifactor models, across all expiry dates and over all underlying swap maturities. Effective out-of-sample pricing is necessary but not sufficient for good hedging. Indeed, regarding hedging, we show there are significant benefits in using multifactor models. This is true even if one accounts for the fact that fewer hedging instruments are required when single factor models are used to hedge swaptions. Our empirical findings have strong implications for the modeling and risk management of an array of actively traded derivatives that closely relate to swaptions.

Keywords: Interest Rate Derivatives, Swaptions, Volatility Structures, Pricing, Hedging

JEL Classification: G12, G13, G19

Suggested Citation

Fan, Rong and Gupta, Anurag and Ritchken, Peter H., On Pricing and Hedging in the Swaption Market: How Many Factors, Really? (July 3, 2007). Available at SSRN: https://ssrn.com/abstract=285958 or http://dx.doi.org/10.2139/ssrn.285958

Rong Fan

Gifford Fong Associates ( email )

3658 Mt. Diablo Blvd.
Suite 200
Lafayette, CA 94549
United States
925-299-7800 (Phone)

Anurag Gupta (Contact Author)

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-2938 (Phone)
216-368-4776 (Fax)

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

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