Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets

Weatherhead School of Management Finance Department Working Paper

34 Pages Posted: 15 Aug 2002

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

Multiple version iconThere are 2 versions of this paper

Date Written: August 13, 2002

Abstract

This paper examines whether higher order multifactor models, with state variables linked solely to the full set of underlying LIBOR-swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the underlying LIBOR-swap market.

Keywords: Interest Rate Derivatives, Swaptions, Delta and Gamma Neutral Hedging, Unspanned Stochastic Volatility, Spanning

JEL Classification: G12, G13, G19

Suggested Citation

Fan, Rong and Gupta, Anurag and Ritchken, Peter H., Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets (August 13, 2002). Weatherhead School of Management Finance Department Working Paper. Available at SSRN: https://ssrn.com/abstract=311580 or http://dx.doi.org/10.2139/ssrn.311580

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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