Risk Managing Bermudan Swaptions in the Libor BGM Model

Raoul Pietersz () and Antoon Pelsser ()

Finance from EconWPA

Abstract: 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 (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin and nep-rmg
Date: 2005-02-11
Note: Type of Document - pdf; pages: 22
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http://129.3.20.41/eps/fin/papers/0502/0502004.pdf (application/pdf)

Related works:
Working Paper: Risk managing bermudan swaptions in the libor BGM model (2003)
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0502004

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