A Semi-Static Replication Method for Bermudan Swaptions under an Affine Multi-Factor Model

Jori Hoencamp (), Shashi Jain and Drona Kandhai
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Jori Hoencamp: Informatics Institute, University of Amsterdam, Science Park 904, 1098XH Amsterdam, The Netherlands
Shashi Jain: Indian Institute of Science, Department of Management Studies, Bangalore 560012, India
Drona Kandhai: Informatics Institute, University of Amsterdam, Science Park 904, 1098XH Amsterdam, The Netherlands

Risks, 2023, vol. 11, issue 10, 1-41

Abstract: We present a semi-static replication algorithm for Bermudan swaptions under an affine, multi-factor term structure model. In contrast to dynamic replication, which needs to be continuously updated as the market moves, a semi-static replication needs to be rebalanced on just a finite number of instances. We show that the exotic derivative can be decomposed into a portfolio of vanilla discount bond options, which mirrors its value as the market moves and can be priced in closed form. This paves the way toward the efficient numerical simulation of xVA, market, and credit risk metrics for which forward valuation is the key ingredient. The static portfolio composition is obtained by regressing the target option’s value using an interpretable, artificial neural network. Leveraging the universal approximation power of neural networks, we prove that the replication error can be arbitrarily small for a sufficiently large portfolio. A direct, a lower bound, and an upper bound estimator for the Bermudan swaption price are inferred from the replication algorithm. Additionally, closed-form error margins to the price statistics are determined. We practically study the accuracy and convergence of the method through several numerical experiments. The results indicate that the semi-static replication approaches the LSM benchmark with basis point accuracy and provides tight, efficient error bounds. For in-model simulations, the semi-static replication outperforms a traditional dynamic hedge.

Keywords: semi-static replication; Bermudan swaptions; affine term structure models (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2023
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