A Comparison of Single Factor Markov-Functional and Multi Factor Market Models
30 Pages Posted: 26 Aug 2006
Date Written: April 3, 2005
We compare single factor Markov-functional and multi factor market models for hedging performance of Bermudan swaptions. We show that hedging performance of both models is comparable, thereby supporting the claim that Bermudan swaptions can be adequately riskmanaged with single factor models. Moreover, we show that the impact of smile can be much larger than the impact of correlation. We propose a new method for calculating risk sensitivities of callable products in market models, which is a modification of the least-squares Monte Carlo method. The hedge results show that this new method enables proper functioning of market models as risk-management tools.
Keywords: Markov-functional model, market model, Bermudan swaption, terminal correlation, hedging, Greeks for callable products, smile
JEL Classification: M, G3, G13
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