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

Raoul Pietersz () and Antoon Pelsser

ERIM Report Series Research in Management from Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam

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 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: Bermudan swaption; Greeks for callable products; Markov-functional model; hedging; market model; smile; terminal correlation (search for similar items in EconPapers)
JEL-codes: G13 G3 M (search for similar items in EconPapers)
Date: 2005-04-03
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Related works:
Journal Article: A comparison of single factor Markov-functional and multi factor market models (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:ems:eureri:1930

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