SIMULATED SWAPTION DELTA–HEDGING IN THE LOGNORMAL FORWARD LIBOR MODEL

Tim Dun, Geoff Barton and Erik Schlogl
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Tim Dun: Department of Chemical Engineering, University of Sydney, NSW 2006, Australia
Geoff Barton: Department of Chemical Engineering, University of Sydney, NSW 2006, Australia

International Journal of Theoretical and Applied Finance (IJTAF), 2001, vol. 04, issue 04, 677-709

Abstract: Alternative approaches to hedging swaptions are explored and tested by simulation. Hedging methods implied by the Black swaption formula are compared with a lognormal forward LIBOR model approach encompassing all the relevant forward rates. The simulation is undertaken within the LIBOR model framework for a range of swaptions and volatility structures. Despite incompatibilities with the model assumptions, the Black method performs equally well as the LIBOR method, yielding very similar distributions for the hedging profit and loss — even at high rehedging frequencies. This result demonstrates the robustness of the Black hedging technique and implies that — being simpler and generally better understood by financial practitioners — it would be the preferred method in practice.

Keywords: Term structure of interest rates; hedging; simulation; lognormal forward LIBOR model (search for similar items in EconPapers)
Date: 2001
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Working Paper: Simulated Swaption Delta-Hedging in the Lognormal Forward Libor Model (2000)
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DOI: 10.1142/S0219024901001127

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