Risk Managing Bermudan Swaptions in the Libor BGM Model

22 Pages Posted: 17 May 2003 Last revised: 9 May 2011

Date Written: December 23, 2003


This article presents a novel approach for calculating swap vega per bucket in the Libor BGM model. We show that for some forms of the volatility an approach based on re-calibration may lead to a large uncertainty in estimated swap vega, as the instantaneous volatility structure may be distorted by re-calibration. This does not happen in the case of constant swap rate volatility. We then derive an alternative approach, not based on re-calibration, by comparison with the swap market model. The strength of the method is that it accurately estimates vegas for any volatility function and at a low number of simulation paths. The key to the method is that the perturbation in the Libor volatility is distributed in a clear, stable and well understood fashion, whereas in the re-calibration method the change in volatility is hidden and potentially unstable.

Keywords: central interest rate model, Libor BGM model, swaption vega, risk management, swap market model, Bermudan swaption

JEL Classification: G13

Suggested Citation

Pietersz, Raoul and Pelsser, Antoon A. J., Risk Managing Bermudan Swaptions in the Libor BGM Model (December 23, 2003). Journal of Derivatives, Vol. 11, No. 3, 2004. Available at SSRN: https://ssrn.com/abstract=383580 or http://dx.doi.org/10.2139/ssrn.383580

Antoon A. J. Pelsser

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD

HOME PAGE: http://https://sites.google.com/site/apelsseraca/

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE

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