On the Suboptimality of Single-Factor Exercise Strategies for Bermudan Swaptions
Mikkel Svenstrup ()
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Mikkel Svenstrup: Department of Finance, Aarhus School of Business, Postal: Fuglesangs Allé 4, 8210 Aarhus V, Denmark, http://www.asb.dk/EOK/FIN/STAFF/MSV_FORM.HTM
No 02-24, Finance Working Papers from University of Aarhus, Aarhus School of Business, Department of Business Studies
Abstract:
In this paper we examine the cost of using recalibrated single-factor
models to determine the exercise strategy for Bermudan swaptions in a
multi-factor world. We demonstrate that single-factor exercise strategies
applied in a multi-factor world only give rise to economically insignificant
losses. Furthermore, we find that the conditional model risk as defined
in Longstaff, Santa-Clara & Schwartz (2001), is statistically insignificant
given the number of observations. Additional tests using the Primal-Dual
algorithm of Andersen & Broadie (2001) indicate that losses found in
Longstaff et al. (2001) cannot as claimed be ascribed to the number of
factors. Finally we find that for valuation of Bermudan swaptions with
long exercise periods, the simple approach proposed in Andersen (2000)
is outperformed by the Least Square Monte Carlo method of Longstaff &
Schwartz (2001) and, surprisingly, also by the exercise strategies from the
single-factor models.
Keywords: Bermudan swaption; American option; Least Square Monte Carlo; Libor Market Model; Model Risk; Model Calibration (search for similar items in EconPapers)
Pages: 38 pages
Date: 2003-05-09
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Persistent link: https://EconPapers.repec.org/RePEc:hhb:aarfin:2002_024
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