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

Posted: 9 Oct 2003

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

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Abstract

This paper examines whether higher order multifactor models, with state variables linked to 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 LIBOR-swap market.

Suggested Citation

Fan, Rong and Gupta, Anurag and Ritchken, Peter H., Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets. Journal of Finance, Vol. 58, pp. 2219-2248, October 2003. Available at SSRN: https://ssrn.com/abstract=447376

Rong Fan (Contact Author)

Gifford Fong Associates ( email )

3658 Mt. Diablo Blvd.
Suite 200
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Anurag Gupta

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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