Risk managing bermudan swaptions in the libor BGM model
AbstractThis 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.
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Bibliographic InfoPaper provided by Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute in its series Econometric Institute Research Papers with number EI 2003-33.
Date of creation: 07 Aug 2003
Date of revision:
bermudan swaptions; central interest rate model; libor BGM model; risk management; swap market model;
Other versions of this item:
- Raoul Pietersz & Antoon Pelsser, 2005. "Risk Managing Bermudan Swaptions in the Libor BGM Model," Finance 0502004, EconWPA.
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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