Swaption Portfolio Risk Management: Optimal Model Selection in Different Interest Rate Regimes

Abstract

We formulate a risk-based swaption portfolio management framework for profit-and-loss (P&L) explanation. We analyze the implication of using the right volatility backbone in the pricing model from a hedging perspective, and demonstrate the importance of incorporating stability and robustness measure as part of the calibration process for optimal model selection. We also derive a displaced-diffusion stochastic volatility (DDSV) model with a closed-form analytical expression to handle negative interest rates. Finally, we show that our framework is able to identify the optimal pricing model, which leads to superior P&L explanation and hedging performance.

Keywords: derivatives valuation, interest rate markets, swaptions, risk management, portfolio management, pricing and hedging, stochastic volatility models, SABR model

JEL Classification: G12, G13