A Comparison of Single Factor Markov-functional and Multi Factor Market Models

Raoul Pietersz () and Antoon Pelsser

Finance from University Library of Munich, Germany

Abstract: 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 risk-managed 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 (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2005-02-11
New Economics Papers: this item is included in nep-fin and nep-rmg
Note: Type of Document - pdf; pages: 27
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https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0502/0502008.pdf (application/pdf)

Related works:
Journal Article: A comparison of single factor Markov-functional and multi factor market models (2010)
Working Paper: A Comparison of Single Factor Markov-Functional and Multi Factor Market Models (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0502008

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