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

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  • Pietersz, R.
  • Pelsser, A.A.J.

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.

Suggested Citation

  • Pietersz, R. & Pelsser, A.A.J., 2005. "A Comparison of Single Factor Markov-Functional and Multi Factor Market Models," ERIM Report Series Research in Management ERS-2005-008-F&A, 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.
    • Handle: RePEc:ems:eureri:1930
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    More about this item

    Keywords

    Bermudan swaption; Greeks for callable products; Markov-functional model; hedging; market model; smile; terminal correlation;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics

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